How to keep the cottage in the family

With cottage season around the corner, many owners will start thinking again about the value of their recreational property, whether to hand it over to their kids – and when.

Transferring a recreational property to the next generation requires careful tax and estate planning, not to mention some open and frank discussions in the family about which children want the property, and how they'll pay for its upkeep. Experts recommend planning well ahead to avoid stress, family feuds and potentially hefty tax and other bills down the road.

"There are the real issues and there are tax and legal issues," says Jamie Golombek, managing director of tax and estate planning at CIBC Wealth Strategies Group.

"The real issue is, do you want to keep the cottage in the family? That's key. If you don't the planning changes dramatically."

The tax implications of keeping it in the family

Most parents try to keep their recreational property in the family for sentimental reasons – and because it's part of the estate they plan to pass along when they die.

"You need to have a discussion with your adult children at some point as to whether they want it," Mr. Golombek says. "Then you need to determine who gets it, how, when – and how they're going to pay for it."

Assuming the cottage isn't a principal residence, capital-gains tax will need to be paid when it's sold or transferred to the kids as part of an estate, which usually happens after the last parent dies. Those gains could be significant, especially if the cottage has been in the family for years, given the steady increase in property prices across Canada "The first thing that stands out as a shocker to most families is how much the tax is actually going to be," says Armando Minicucci, principal of tax services at Grant Thornton. "Most families lose sight of the fact that there's a capital-gains tax that's triggered … when the second spouse passes away," and the assets are transferred to the next generation.

Mr. Minicucci cites an example of a family whose children inherited a cottage in Ontario valued at $1.2-million, with a capital gain of about $900,000. Under current tax rules, 50 per cent of that gain is subject to tax.

Under a case like that, the income tax is about $240,000 and needs to be paid by the filing due date of the deceased's date of death tax filing, generally April 30 of the year following death. In Ontario, there is also $18,000 of probate. The problem arises when the estate inherited by the children can't cover the tax liability. The children may be forced to sell the cottage just to pay the tax bill, which may not be what the parents intended.

"With the significant gains realized of late in the real estate market, it's not uncommon for an estate to consist primarily of real estate with insufficient liquid assets to cover the tax liability," Mr. Minicucci says.

Some parents decide to transfer the property before they die, or gift it, and pay the capital-gains tax, Mr. Minicucci says. Often when gifted to their children, they may choose to pay for the maintenance and upkeep as long as they're alive, especially if they continue to use it. One issue that can arise when transferring the property to the kids is when one of them is married and then gets divorced. Under family law in Ontario and some other provinces, an ex-spouse could have a claim to half the value of their spouse's interest in the property if it's considered a matrimonial home.

Using a trust

Families can try to protect the property from a matrimonial claim by creating a trust. A trust is a relationship that separates the legal ownership of property from the beneficial use and enjoyment of it. Moving a property into a trust will often trigger a capital gain, however. That's why experts such as Mr. Golombek recommend setting up a trust when buying a new property or when it's had little or no accrued capital gain, or even a loss. Any future capital-gains tax will be deferred until the trust's beneficiaries, who are usually the children, sell the property or if they die and it's passed on in their estate.

One major consideration, though, is what's known as the "21-year rule," which states there's a "deemed disposition" of the trust's property on each 21st anniversary of the trust. Mr. Golombek said that could lead to 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."

He said the tax can be avoided here if the property is distributed to the trust's beneficiaries within the 21-year period. This can be a problem, however, if the beneficiaries aren't ready to take over the property before the 21 years are up. That's why Mr. Golombek recommends starting this type of arrangement when the children are at least adults.

When one child doesn't want the cottage

It's common in estate planning that one or more kids don't want the cottage, for various reasons, which means parents looking to distribute their assets equally need to find a way to equalize the estate.

Maybe the other kids get part of the RRSP, or the house in the city. Or, Mr. Golombek says, parents can consider buying a permanent life-insurance policy that pays out to the child who doesn't want the cottage, at a value equal to other assets being transferred. A life-insurance policy can also be used to help cover costs of maintaining the cottage for the kids who keep it. It can even be used to cover the capital-gains tax if the property is sold.

"These are real issues that we talk about in every client meeting we have where the client owns a recreational property," Mr. Golombek says, urging families to talk openly about what their wishes are for the asset.

"Before you do any planning … you need to have a discussion with the kids," he says.