You love the cottage and hope it will stay in the family for generations to come, but will it?
The biggest concern that people face when transferring the cottage to the next generation is the capital gains tax when sold. You can defer the tax payment with a spousal rollover upon your death. However, after the death of your spouse, the Canada Revenue Agency will want to be paid. Will your estate be able to cover the tax liability?
What is capital gains tax on a cottage?
Example: Someone purchased a cottage for $200,000 and the value increased to $700,000 by the time it is to be passed on to the next generation. Based on a 40% marginal tax rate, the estate would be stuck with a $100,000 tax liability that would need to be paid.
Let’s walk through how capital gains tax works for the above example. When you first acquire an asset, it has a value (called the adjusted cost base). In the above example, the adjusted cost base would be $200,000, which was the price that was paid for the property. The value of that property should increase in value overtime and the longer you own it, the more it would likely increase. The difference between the value when you first acquired the property and the day you decide to sell it (or transfer it at time of death) is known as the capital gain. In the above example, the capital gain would be $500,000. You need to pay tax on 50% of that value. You don’t need to pay $250,000 in taxes, but rather that $250,000 would be added to income for that year on the tax return. Based on a 40% marginal tax rate, the capital gains tax owing would be $100,000.
What is the principal residence rule?
One rule about capital gains that is important to know is that a person does not have to pay capital gains tax on their principal residence. Your principal residence doesn’t necessarily have to be the house you live in most of the time. If your cottage happens to be worth more than your principal residence, you may want to talk to your accountant to see if it makes sense to designate your cottage as your principal residence. Couples and their unmarried minor children can only designate one home in total as a principal residence.
Can I not just gift the cottage to my children?
I have heard many clients tell me that they are planning to just ‘gift’ their cottage to their children. If you are thinking of just ‘gifting’ the cottage to your children, keep in mind that the taxman must still be paid. Capital gains tax would be payable by the estate when the final tax return is filed for the deceased. It is the responsibility of the executors to ensure that those taxes are paid. If the capital gains tax was not paid, it would lead to the taxman knocking at the door to collect the outstanding capital gains tax along with interest and penalty.
Talk to your kids
Don’t just assume that your children want the cottage. What happens if one wants the cottage and the other doesn’t, it may lead to a forced sale of the property and cause family conflict. Sit down with your children and find out what their plans are. They might not want to take on the additional costs or have plans to purchase their own properties in the future.
Buy a life insurance policy.
A common means to cover capital gains tax on a cottage is to purchase a life insurance policy which will help to avoid the forced sale of estate assets upon death. However, life insurance should be considered earlier in life as the insurance does become more expensive as you get older, and may become prohibitive in your senior years. You could also use life insurance to equalize the estate if one or more child does not want to keep the cottage and would prefer to split the proceeds of the sale. Based on the above example, the $100,000 tax-free payout would cost a 60 year old couple roughly $135 per month to purchase a joint-last-to-die permanent policy. This is a small price to pay to have the peace of mind in knowing that their heirs will not be left with a tax liability and the cottage can be passed along as they wished.