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Estate Planning - Preserving The Family Cottage

By: Jamie Golombek
October 2009

Whether it’s the cabin, condo, chalet or cottage, your vacation property is likely full of happy family memories that you wish to preserve for future generations. Unbeknownst to you, however, is that lurking under the surface of your idyllic retreat may be a host of tax and estate planning issues that, if not tackled early on, could not only cost you (or your heirs) a lot of cash and, in extreme cases, could force the sale of the recreational property that may have been in your family for generations.

With some professional advice and some advance planning, however, you may be able to mitigate some of these potential problems.

Family VacationIncome Tax Planning

Perhaps the biggest tax problem associated with the vacation property is the potential for capital gains tax upon either the sale or gift of the property or upon the death of the owner.

If you sell or gift the property while you are alive, you will generally be taxed on the difference between the amount you receive (the ‘proceeds of disposition’) and the adjusted cost base (ACB) or tax cost of the property.

While many parents may wish to give the vacation property to their kids, either while they are alive, or upon death, doing so will result in an immediate capital gain if the property has gone up in value since the date of acquisition.

As a result, we need to explore some tax planning strategies to either permanently avoid the capital gains tax or, at the very least, to defer paying it as long as possible.

  • Principal Residence Exemption

The principal residence exemption (PRE), if available, can shelter the gain on a principal residence from capital gains tax. A principal residence can include a vacation property, even if it’s not where you primarily live during the year as long as you ‘ordinarily inhabit’ it at some point during the year.

A cottage is considered to be ordinarily inhabited by someone, even if that person lives in that property for only a short period of time during the year (such as during the summer months), as long as the main reason for owning the property is not for the purpose of earning income.

Since 1982, a couple can only designate one property between them as their principal residence for any particular calendar year. This becomes a challenge when a couple owns more than one principal residence and is forced to choose, upon ultimate sale of the first one, which property will be designated the principal residence for each year during the period of multi-home ownership.

As a result, a conscious decision should be made when you sell one of your personal residential properties as to whether the gain should be reported since failure to report will result in the assumption by the CRA that the ‘sold property’ has been designated as your principal residence for the years you owned it, precluding you from using the PRE in the future on the sale of your other property, at least during the overlapping years.

Generally, the decision to claim the PRE when you sell your vacation property as opposed to ‘saving it’ for the disposition of your other property will depend on a number of factors, including the average annual gain on each property (the gain on each property divided by the number of years each was held), the potential for future increases (or decreases) in the value of the unsold property, and the anticipated holding period of the unsold property.

Non-economic factors may also come into play as you may be more concerned about a current, immediate tax liability today versus a tax liability payable later on (say upon death, by your estate) on the sale of your other property.

  • Life Insurance

Although numerous planning ideas are available to reduce or defer tax liability on the transfer of the cottage, one of the simplest is buy a permanent life insurance policy to offset the tax liability upon death. The tax advantage is that the death benefit is received tax-free.
Practically speaking, however, life insurance may not always be feasible. If the cottage owner is in his or her 70s or older, he or she may be uninsurable or the premiums prohibitively expensive.

  • Use of a Trust

A trust is not a legal entity, but rather a relationship that separates the legal ownership of property from the beneficial use and enjoyment of that property.

In a typical scenario, the property’s current owner (the trust’s ‘settlor’) would settle the property with a ‘trustee,’ perhaps the owner’s spouse or partner, for the benefit of their kids (the ‘beneficiaries.’)

The problem with using a trust for a property you currently own is that a transfer of the property to a trust may trigger immediate capital gains tax.  There are specific exceptions (such as a transfer to an ‘alter-ego trust,’ discussed below.)

Estate PlanningOn the other hand, if you are purchasing a new property or own one that has little or no accrued capital gains or even a loss, you may wish to purchase the property through the trust or transfer the existing property into a trust today so that any future capital gains tax that arises can be deferred until the trust’s beneficiaries (generally the children) ultimately sell the property.

The trust deed may permit you to enjoy the use of the property during your lifetime. Later on, when you find you are no longer using the property as much, it can be distributed from the trust to the appropriate beneficiaries.

When the property is distributed from the trust, it can generally be ‘rolled out’ to the beneficiaries at the original ACB of the property, and thus tax would be deferred until the property is sold by the beneficiary. The beneficiary of the family trust who receives the property is deemed to have owned it since the trust acquired it for the purposes of claiming the PRE upon its ultimate sale. This allows a child who is the beneficiary of a trust that held the vacation property and who did not own another home while the property was in the trust, to use the PRE to potentially shelter the entire gain from the date of original purchase by the trust to the date the property is ultimately sold by the beneficiary.

Perhaps the biggest problem, however, stemming from using a trust to hold the vacation property is the ‘21-year rule.’ This rule states that there is a deemed disposition of the trust’s property on each 21st anniversary of the trust, which could result in a capital gain on property held in the trust, accelerating the tax liability which otherwise may have been deferred until the last-to-die of the parents who originally owned the vacation property. Note that tax obligation occurring as a result of the 21-year rule can be avoided by distributing the property to the trust’s beneficiaries within the 21-year period, as discussed above. The 21-year rule will create difficulties where the beneficiaries are too young to receive a share of the property within that timeframe.

While the trust may be able to claim the PRE to shelter the gain on this disposition, that may cause problems if the children who are beneficiaries of the trust also own their own homes as it would preclude them from using the PRE to shelter a gain from the sale of those homes. Similarly, if a beneficiary has used the PRE on another property, the trust cannot designate the property as a principal residence for those years.

Probate Fee Planning

Upon death, each province (except Quebec) levies a probate fee on the value of assets passed through the estate. That probate fee ranges from 0.4 per cent in Prince Edward Island to 1.5 per cent in Ontario. Only Alberta and the territories have maximum caps of $400 ($140 in the Yukon). For example, an Ontarian who wills her $500,000 Muskoka cottage to her kids would face a probate bill of about $7,500.

In fact, without proper planning, a vacation property could be subject to probate fees twice – once on the death of the original owner and, if left to a spouse or partner, again on the death of the survivor.

There are some common planning techniques that may be helpful to reduce or eliminate probate fees payable upon death.

Estate PlanningJoint Ownership

One common probate-avoidance technique is to register title of the property in joint tenancy (each joint owner has an undivided interest in the entire property). This type of joint ownership with right of survivorship means that upon the death of one owner the property is simply transferred directly to the surviving joint owner, bypassing the estate and therefore, not subject to probate.

The advantage of joint ownership, however, is mired in a plethora of other problems, some of which may be more significant than the probate bill. The biggest problem, and the subject of two 2007 Supreme Court of Canada cases, is proving the true intention of the transfer – was it a gift or merely an estate planning strategy?

For example, say Jack transfers his $1 million Whistler, BC, condo to joint title with his adult daughter, Jill, whose family vacations there on weekends in summer and skis there for two weeks during Christmas. Jack’s other child, Jane, lives in Halifax, NS, and does not use the property at all.

Upon Jack’s death, the property will simply transfer directly to Jill’s name, bypassing the estate and avoiding B.C. probate fees of $14,000 (at the 1.4 per cent B.C. rate). But did Jack really intend for Jill to inherit the entire value of the condo, to the exclusion of Jane? What if the condo was the only major asset owned by Jack upon his death and there was little else left in his estate for Jane?

If the two recent Supreme Court cases on this topic are any indication of what might happen in this hypothetical example, Jane would likely hire a lawyer and sue her sister for half the value of the condo, arguing that the transfer into joint ownership was merely an estate-planning ploy meant to avoid probate. Surely, Dad didn't intend to disinherit Jane – or did he?

  • Trusts, Including ‘Alter-ego Trusts’

Using trusts to hold vacation property can help to avoid probate fees upon death since property inside the trust is not included in the value of your estate. As discussed above, however, transferring the vacation property with the accrued gain into the trust could give rise to capital gains tax, which could negate the ultimate probate avoidance motivation.

That being said, if you are at least 65 years of age, you may wish to consider transferring the vacation property into an ‘alter-ego trust’ or a ‘joint-partner trust,’ which can be done without having to pay immediate capital gains tax on the transfer. In order to be an alter-ego trust or joint partner trust, no one other than you (or you and your spouse or joint partner, in the case of a joint partner trust) can be entitled to the income and capital of the trust during your lifetime.

You can continue to maintain full control of the property through the trust, but you can name your children as the ultimate beneficiaries of the trust, who would then inherit the property upon your death. Since at the time of death you no longer own the property – it's owned by the trust – it's not included in the value of your estate for the purposes of calculating probate fees.

Jamie Golombek, CA, CPA, CFP, CLU, TEP, is managing director, tax and estate planning, with CIBC Private Wealth Management in Toronto, ON.

 

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