Depending on where you live in Canada, your family vacation home may be called a cottage, cabin, chalet or camp. No matter what you call this retreat, it likely holds cherished family memories, and you may want to pass it down to the next generation.
But keeping the cottage in the family can be expensive. Capital gains tax is a major obstacle, given that the price of real estate has risen dramatically in many parts of Canada over the years — and recreational properties are no exception.
How capital gains affect your cottage transfer
Real estate is a capital asset, meaning that if you sell it, you have a capital gain or a capital loss, depending on whether it increased or decreased in value since you acquired it.
Let’s say you own a cabin that is not designated as your principal residence (more on this below). On your death, you can have the property transferred to your spouse without triggering a disposition (that means the government doesn’t deem you to have sold it, and no tax is payable).
If you have no surviving spouse, or your spouse is not inheriting the cabin or does not agree to accept it on a tax rollover basis (that is, deferring the taxes to your spouse’s death), the cabin is deemed to have been disposed of at fair market value, and the government will expect payment of the taxes owing.
If the property has risen in value dramatically, capital gains can sometimes be so high that your heirs have no choice but to sell the property to pay the tax.
For example, if the property’s value increases by $500,000 between when it was purchased and when it is disposed of (either because of your death or because of the sale of the property), 50% of the gross capital gain is taxable. That means a person could see their taxable income increase by $250,000 — a sizable increase that could result in having to sell the property to pay the tax.
How to manage the capital gains tax
Here are a few strategies to cover the impending tax liability upon your death.
Principal residence exemption: If you dispose of a property that’s considered your principal residence, there is no capital gains tax payable when you sell or when you are deemed to have disposed of the property (assuming it has increased in value). Since you and your family unit (spouse and minor children) can designate one principal residence per year, your cabin (instead of your house) could be considered your principal residence for one, some or all of the years you owned it. If you own more than one property, you should speak to your tax advisor about how to best make use of this exemption.
Tracking capital expenditures: Keeping track of the initial investment and any capital improvements to the property can help reduce any future capital gain.
The combined amount — known as the adjusted cost base — is used to calculate the capital gain. If you have qualified capital improvement costs to add to your adjusted cost base, the cost base is higher, and the resulting capital gain will be lower. To qualify as a capital improvement, the costs incurred must improve the property’s overall value or useful life. For example, an addition or a deck could qualify, while interior painting generally would not. Keeping good records (i.e., all receipts) is important.
If you’re not sure about whether the receipt or improvement counts for this purpose, talk to your tax advisor.
Life insurance: Life insurance is the most common way to ensure funds are in place and available to cover the taxes owed upon your death. With a permanent life insurance policy in place, your executor or beneficiaries will receive a tax-free death benefit that can be used to help pay the taxes owing and keep your cottage in the family.
Transferring property before you die
Here are some strategies you can implement while you’re alive to help reduce your tax liability upon your death.
Capital gains reserve: You can sell the property but take payment over a five-year period. If you claim what’s called a “capital gains reserve” in this way, the tax liability can be spread out over five years. The tax liability will still exist, but the burden will be paid over a five-year period. Talk to your tax advisor about who can claim a capital gains reserve and the intricacies of how it works.
Promissory note: You can sell the property to your children at fair market value, with part of the purchase price paid by a promissory note. This promissory note would not be collected upon, and in your will, this note would be forgiven. Your children would pay the tax cost equal to the fair market value at the time of their purchase, but they would not pay off the promissory note. The purchasing family member would have to be comfortable that this promissory note remains legally outstanding and could be called for payment until — and if — it is forgiven by you.
Plan ahead to keep the cabin in the family
If your goal is to leave this asset to your loved ones, proper planning can help you to ensure they will continue to enjoy your vacation property when you are gone.
An MD Advisor* and MD Estate and Trust Advisor can help determine the best solution for your situation.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.
Estate and trust services are offered through MD Private Trust Company.
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.