Many cottage owners—especially those who love to use the space as a place to gather their families, share time and create lasting memories—like to imagine that when they are gone, the traditions will continue, and the cottage will be enjoyed by their children, grandchildren, and great grandchildren for years to come. In this way, the vacation property, for many, accrues a deep emotional value that far outweighs what it represents in terms of dollars and cents.
This emotional gravity can make already complicated decisions around legacy planning even more complex. You want your kids to have the cottage so they can enjoy it after you’re gone. It sounds like a simple plan, but executing it properly—if everyone involved is on board with it—requires careful preparation.
And settling that crucial “if” is key. “Communication is a fundamental part of the continuity planning process,” explains Paul Morse, Senior Investment Advisor and Founder of Morse Wealth. Sometimes, even though they visit a lot now and have a great time, parents are surprised to learn that their kids actually don’t want to inherit the cottage. The upkeep and commitment of a seasonal home isn’t something everyone wants to, or can, take on, and some families may prefer to keep their time and resources open for travel or other pursuits. “Whatever their own vision might be,” says Paul, “what most people really want is to create a plan that is inclusive and takes into account the interests of everyone involved.”
Consider a simple scenario that many will relate to: Let’s say two parents own a cottage in Muskoka that they bought in 1980 for $350,000. They also own a home in Toronto that they purchased in 1990 for $450,000. Today, the fair market value of the cottage is $4,500,000. The house also has a fair market value of $6,500,000. The parents have two grown children. In order to treat both children equally, they plan to leave the house to one child, and the cottage to the other. The properties have sentimental value to children and both have expressed an interest in owning their respective inheritance properties. This seems to make sense, right? No so, explains Paul.
“In estate planning, the common refrain is, treating people fairly doesn’t always mean treating them the same.”
In the scenario just described, assuming the parents maintained the house in Toronto as their principal residence, when the second parent passes away, the inheritance of the house will proceed tax-free, whereas in the inheritance of the cottage, the estate will bear the burden of a capital gains tax somewhere in the neighbourhood of $1,100,000. If the estate does not have that amount in residue, the cottage may need to be sold—and fast—to pay the tax.
There is also the issue of equalization. In this scenario there is a $2,000,000 gap between the property values. If the parents want to treat both children equally, this would require additional planning.
In short, capital gains tax is triggered whenever there is a change in title on a property, whether that’s through a sale or by adding a name to the ownership deed. That’s why simply putting the cottage in your loved one’s name isn’t a way around the problem. To understand how capital gains tax is calculated, begin by subtracting the price of the property when it was purchased (or the last time the capital gain was triggered) from its current fair market value. In the scenario above, the cottage was purchased for $350,000 and is now valued at $4,500,000, so the capital gain is $4,150,000. Fifty percent of that gain is considered taxable income.
One way to avoid incurring a capital gains tax on your cottage is to designate it as your principal residence. This doesn’t mean that you have to live there all the time, but you are required to occupy the building at least occasionally.
This is a good option for some circumstances. However, if like many Muskoka cottagers, your house is in Toronto, it may actually cost your estate more to pay the capital gains tax on the house than it would to pay it on the cottage. Furthermore, the Income Tax Act requires that in order to qualify for the principal residence tax exemption, a home must be designated as the principal residence in the year of sale. To be eligible for the exemption on prior years, the home must have qualified as the principal residence during those years.
Some clients approach the professionals at Morse Wealth with the idea of gifting their intended beneficiary the cottage while they are alive and not as part of their estate after death. Unfortunately, that doesn’t resolve the problem of taxation.
The Income Tax Act regards a transfer of ownership as a sale for fair market value regardless of whether any money has actually changed hands and therefore such a gift will trigger an immediate capital gain.
Therefore, adding a child or children as co-owners will trigger a capital gain on the portion of ownership that changes hands. Even without these considerations, giving your offspring full or partial ownership of the cottage also gives them full or partial legal control, and creates vulnerabilities that may be exploited if they experience a separation or divorce, or they have insolvency issues down the road.
At Morse Wealth, we work with a multidisciplinary team of TD specialists works with each client to craft a plan for each client that takes into account the unique interplay of their specific situation. It’s an approach that Paul swears by. “With complex estates, I believe that an integrated perspective is key to finding the best solution for the client,” he explains. It is never a one-size-fits all solution – different properties, changing tax rules, varying legislation across jurisdictions and family dynamics often come into play. Paul, who is currently in the Family Enterprise Advisor (FEA) program and working towards attaining his FEA designation, has seen it all before. He has worked with enterprising families for 25+ years - helping them engineer solutions aligned to the vision they have for their lives and legacies. The multidisciplinary specialists include a High Net Worth Planner, Tax & Estate Planner, Business Succession Advisor and Estate Planning Advisor.
“Our approach is grounded in good communication, involving everyone in the planning process,” Paul explains. “Then we move on to strategies and tactics that are going to crystallize the outcomes that you’re looking for. This is where our multidisciplinary advising comes in.”
As opposed to having an accountant that you’re talking to, a lawyer that you’re talking to, and a wealth manager that you’re talking to, all those perspectives are represented together at the table. Regardless, all cottage owners should keep assiduous records of any investments that have been made in the property, such as new docks and renovations. The capital gain can then be calculated against the original cost plus the cost of these capital improvements in the property, which will increase the adjusted cost base and thus lessen the gap between the cost base and the fair market value at the time of inheritance or sale.
One option, for younger clients especially, is the purchase of life insurance. By calculating the amount of insurance they’ll need in order for the payout to cover the capital gains tax on the cottage, they can ease or eliminate the burden of the tax for their beneficiaries.
There are other options, too. Parents may consider selling the cottage to one or more children and taking advantage of a provision in the Income Tax Act that allows them to spread the capital gains tax out over a five-year period, for instance. It’s also important to plan for the ongoing costs of keeping a property, which extend beyond the paying of property taxes to things like maintenance, repairs, and security. Planning for a smooth transition means planning to have capital available to keep up with expenses.
Regardless, all cottage owners should keep assiduous records of any investments that have been made in the property, such as new docks and renovations. The capital gain can then be calculated against the original cost plus the cost of these capital improvements in the property, which will increase the adjusted cost base and thus lessen the gap between the cost base and the fair market value at the time of inheritance or sale.
It may be a daunting prospect to sort all of this out, but that burden can be significantly lessened with the help of the team of informed professionals at Morse Wealth. And that first step, at least, is just a phone call away. The takeaway for cottage owners is this: The sooner you get the future of the cottage settled, the sooner you can get back to enjoying it.
To engage the team for consultation:
Paul Morse, CIM®, FCSI
Senior Investment Advisor
TD Wealth Private
Investment Advice
T: 705-330-0036
E: [email protected]
morsewealth.ca
linkedin.com/in/paul-morse-td
