A cottage is a place of pleasure, where friends and family gather far away from the bustle and worries of city life. But when the time comes to figure out what will become of it after you die or are no longer inclined or able to use it as you get older, bliss can transform quickly into worry.
In many cases, the cottage is passed on to the next generation. In a perfect, well financed world, that is the ideal solution. But often one of the children cannot afford to buy out his or her siblings during the estate-distribution process. If the plan is to have all the kids share the property, the same issues of financial inequity can wreak havoc. And even if money isn't an issue, there can be disagreements over maintenance and improvements.
Devising a successful cottage succession scheme can be among the biggest challenges of estate planning. "There are many issues to consider when assessing a cottage's future, a task made all the more difficult by the fact no one situation is the same," says Anthony Layton, chairman of PWL Capital Inc.
Of course, the hassle-free answer to the cottage conundrum is to simply sell the cottage on the market, either during your lifetime or by requiring that this be done in your will. However, a succession solution usually can be found, as long as specific factors are properly addressed, Layton says. Assuming the cottage will remain in the family, there are various strategies to consider, which are based on key issues such as when the property ownership should be transferred, how it is to be valued, how to pay the resulting capital-gains tax, potential use of the principal-residence exemption, and even more complex challenges such as shared-ownership agreements and trust ownership.
Discuss sooner, not later
Start a discussion with family members well before it becomes necessary to make a decision, says Tarsem Basraon, senior manager, Wealth Advisory Services at TD Wealth Management. This will allow everyone to understand what is involved in terms of time and financial commitment -- and also reveal who actually might be interested in taking it on.
"Children enjoy the memories and times spent at the cottage when it was managed by Mom or Dad, but once they understand all of the complexity involved, they may not want the responsibility," Basraon says.
Other issues can include how close one lives to the property, whether their spouse is as interested in cottage life as they are, and whether zoning rules would allow them to improve the cottage according to their wishes.
You can decide to transfer ownership of the cottage through your will, or while you are alive if you want the new owner(s) to assume responsibility sooner, and assume ownership at what would presumably be a lower value than later on at the time of death. Note also that the property can be transferred to your spouse without capital-gains tax being immediately payable, thus deferring the tax liability until he or she dies.
Ownership structure
If only one child wants the cottage, the matter is fairly straightforward -- as long as there are enough assets in the estate to ensure everyone receives an equal inheritance. Thereafter, it would have to be clearly understood that there is a new owner and that the rest of the family won't necessarily have access.
However, if several children are interested -- and in similar financial positions -- it may then be necessary to produce an ownership agreement, or even set up a trust. This can be done in your will, or form part of a sale agreement if you transfer the property while you are still alive.
"An ownership agreement would set out the responsibility of the children with respect to the cottage," says Basraon. It should stipulate who pays the property taxes, who is responsible for maintenance costs, what happens if one of the children dies and how one co-owner could buy another's share.
Trust may make sense for valuable property
If you decide to set up a trust, a trustee would manage the property on behalf of the beneficiaries, typically your children or grandchildren. It's a good idea, says Basraon, to include a reserve fund in the trust. "This can be funded through the use of life insurance or through other liquid assets available in the estate," he says. "The trustees would then be able to use the reserve to pay for the cottage expenses and maintenance fees."
The trust arrangement has some drawbacks, Basraon warns. "You may need to hire a professional trustee to manage the property and there are likely to also be additional fees for other administrative functions such as the filing of annual tax returns and investment-management fees." As a result, he says, a trust usually only makes sense if the property has a high valuation and the intent is for the trust to own the property for a long time. (Note that trusts must report capital gains every 21 years and pay tax on those gains.)
Capital-gains tax
Once it has been agreed who will take on the property, the next challenge is dealing with the capital-gains tax that is likely to be payable when the property is transferred. The amount of tax is based on the property's fair market value, so an outright gift will not escape the tax man's grasp. One-half of capital gains are taxable at your top marginal tax rate.
If you are about to purchase a cottage, consider placing it in the children's or even grandchildren's names. "This defers all or most of the future capital-gains tax liability on the property's expected gain in value by a full generation or longer," Layton says, adding that the sale documents will specify that the parents or grandparent will retain full access and use during their lifetimes. This also can be achieved by structuring the ownership as joint tenancy with the right of survivorship, where the property transfers to the joint owner upon death.
In addition to deferring capital-gains tax, having a younger-generation family member as owner or having a joint tenancy arrangement will bypass probate fees that normally would be payable on estate assets upon death in all provinces except Quebec, Layton says.
Use the principal-residence exemption
A cottage can qualify as your principal residence if, as the taxation rules state, it has been ordinarily inhabited by the owner or family member. So any cottage that is routinely used by the family is eligible. If the cottage is on a large lot, there may be a limit as to how much of the property would qualify for the exemption. Normally this is limited to the one-half of a hectare (or roughly 1.25 acres) that surround the house. "However, more land can be included if it is considered to have contributed to the ‘use and enjoyment' of the residence, says Layton. "For example, it could be argued that a few acres of additional land are essential to provide adequate privacy, or are needed to provide road access to the house or access to the lake from the house."
Of course, if you also own a home in the city or elsewhere, you will need to decide on which property to apply the exemption, depending on which will generate the bigger capital gain and thus attract the most tax. Fortunately, there is a lot of flexibility in how the exemption can be used.
"You are only required to designate a particular piece of real estate as your principal residence for a particular period of time when you sell the real estate or are deemed to have sold the real estate, such as on death or when it is gifted," Basraon says. "Further, you do not need to utilize the exemption all on one piece of property. For example, if you owned a cottage for the last 10 years and a family home for the last 20 years and the gain on the cottage is much larger, you could use the exemption on the family home from years one through 10 and use the exemption on the cottage from years 11 to 20."
A last-minute decision
You do not have to decide how the exemption is best utilized until you file your tax return for the relevant year (that is, when the capital-gains tax is due). If you are selling the cottage during your lifetime, claim the exemption by filing Canada Revenue Agency Form T2091 (or Form T1255 for a deceased person).
For a property that has been owned for a long time, only the amount of a gain since the beginning of 1972 -- when capital-gains taxation took effect -- is subject to tax. Also note that, since the beginning or 1983, a married or common-law couple has been allowed to have only one principal residence between them. However, you can claim the exemption for two principal residences until the end of 1982.
