The cottage is a source of joy for many families, and is often viewed as 'common property' within generations. Like many people, you are perhaps considering leaving the cottage to your heirs so it can be enjoyed by generations to come. Whether you are in this situation, or considering purchasing a cottage for the first time, there are certain financial implications you may want to consider. They might influence how you intend to pass on the cottage to your heirs be it through a will, a sale or perhaps through a trust. And they may also influence how you structure the purchase of a new property today.
When transferring any property, you should first consider the cost impact of the transaction. If you have owned a property for several years, its value is likely to have increased, creating what could potentially be a significant capital gain (assuming the transfer takes place after October 17, 2000). If this is the case, 50% of the appreciated value of a cottage is considered taxable income in the year it is sold or transferred. A major downside of the capital gains tax is that in most cases it is not deferrable the amount owing must be paid immediately. (Note: the sale or transfer of a principal residence is an exception.)
Elizabeth has decided to give the cottage to her only son. When she purchased the cottage, the property had a value of $50,000. Over time, it has appreciated in value to $150,000. Of the $100,000 in appreciated value, $50,000 ($100,000 x 50%) will be considered taxable income in the year of the ownership transfer. Clearly, this could have a significant impact on her tax situation and could affect her Old Age Security benefit.1
While the prospects for an easy transfer of the cottage to a family member might seem grim, with proper care and planning, you can keep the property within your family for the next generation without creating a significant tax burden.
While this solution would appear to be the simplest, the above example shows one of the major pitfalls - the immediate capital gains tax. If you transfer the cottage into your child's name today, you will immediately trigger capital gains, resulting in an additional tax burden for yourself. Even if you sell the cottage at a "bargain" price the government will consider the property to have been sold at fair market value, so you will not be reducing the capital gains tax payable by you. Your child or children, however, will be required to report the "bargain" purchase price as their cost base, creating a larger capital gain for them when they pass away or choose to sell the cottage some time in the future. It is important to be sure of your decision before transferring ownership of the cottage, as you are not only giving up ownership but also control over its use.
This strategy should involve planning by both you and your children, and should be done with the assistance of a will specialist (i.e., a lawyer). If there are multiple heirs, you may want to formulate guidelines for usage and maintenance costs associated with the cottage and set them out in writing. Remember, upon your death, your estate will be liable for the capital gains tax on the disposition of the cottage and, therefore, if any of the children do not want the cottage, their share of the estate will still be responsible for a proportional amount of the tax on the capital gains. If you know now that a child(ren) is not interested in owning the cottage, you might consider stipulating some other form of compensation for them. An insurance policy could be purchased to help offset the taxes due and, if the children purchase this policy, the premiums could be divided among those who will be sharing the cottage after you pass on.
While there is no way to defer taxes forever, by selling the cottage to your children and taking back a demand mortgage with deferred payments, you are permitted to spread the tax payable on the capital gains over five years. At the time of your passing, you can forgive the mortgage in your will and the cottage will be left to your child with no debt or taxes payable.
These are just a few of the options available to you, and they are designed primarily to show you that with proper planning, you can pass on your cottage to your child or children without passing on a significant tax burden as well.
1If you owned your cottage prior to 1981, certain exemptions might apply that are not addressed in this newsletter. Please ask your tax specialist for further information.