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The gesture couldn't be more generous and loving.
Imagine a fairly wealthy elderly couple with a beautiful vacation home on the south shore of Nova Scotia (or in Muskoka, or Whistler, if you prefer). The couple and their children remember decades of summers on the beach.
The couple has decided to leave the cottage to their older son, since his children have also come to love it. The property, which the couple bought years ago for $200,000, is now worth four times that.
Let's assume that the couple's other child, a younger daughter, doesn't plan to use the property as she starts her life in New York. She will be given a comparable inheritance, say $800,000.
Now the unhappy truth: Second homes, cottages and other vacation properties are taxable assets. Unlike a primary residence, the increase in value of a second home is taxed, so the son will receive a major tax hit.
"We see it now particularly because there has been such an escalation of property values," said Suzana Popovic-Montag, a managing partner and specialist in estates and trusts at the Toronto law firm Hull & Hull LLP. "Many people, more than in the past, have a second property or vacation property, and it amounts to a substantial portion of their estate."
But what if the son, given the expense of raising his children, can't afford the huge capital gains tax on the cottage? The tax burden automatically falls to the estate, which could affect the daughter's inheritance. But what if she is desperately counting on her money to pay off her Manhattan condo?
It's something the elderly couple should consider and prepare for. "Whether you gift the property, or you sell the property [to your heirs], or you put it into joint tenancy, or you give it by will, you will have a capital gains hit for the owner of the property," Ms. Popovic-Montag said.
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Jessica Lyle, an estate and trust lawyer at Sealy Cornish Coulthard in Dartmouth, N.S., said many of her older clients are wealthier than their children.
"I've had clients who bought cottages in now-trendy areas, who got it for $1,500, 40 or 50 years ago, and now the property is worth $800,000 or $1-million. They are talking about an $800,000 capital gain, and suddenly the family has to come up with a few hundred thousands of dollars in cash. For some people, that's crazy," Ms. Lyle said.
Families need to provide their estate planners with a clear picture of their financials and the property's value, Ms. Lyle stressed, not just a plan of who should inherit what. "And when I have that, it allows me to start the emotional conversation, too," she said.
One strategy would be for the elderly parents to give the cottage to their adult son while the couple are still alive. The parents would pay the capital gains tax, which in this case would be about $200,000.
The son would then be responsible for the future capital gains, starting from the time he was given the cottage. Then, to make the inheritance equal for the son and daughter, the son would likely get less in the parents' will because he was already given the cottage.
Another method would be to add the son's name onto the title of the property. This is typically done using a bare trust. The adult child's name is added, but there's an understanding – preferably written down – that control rests with the parents. All decisions are theirs.
"The vast majority of Canadians who add kids onto the cottage, whether they realize it or not, are doing it in this bare trust capacity, because very few are then filing on their tax returns that they gifted [it]," Ms. Lyle said. "The bare trust idea then means that on death, the kids know that they have to deal with the cottage in accordance with the will," and pay the property tax accordingly.
Another strategy is to turn the cottage into the parents' principal residence. The mistake often made here is that the change isn't grandfathered. Capital gains still apply to the time the property served as a vacation home. The primary-residence exemption applies only to the length of time the cottage was their primary household.
"On their tax return, they're still going to have to show and account for whatever capital gain is owing for the 25 or 35 years when they owned the cottage at the same time as they owned their house. That sometimes stops the conversation [with clients] right in its tracks," said Ms. Lyle.
Sometimes, though, a capital gains tax bill can be mitigated by other means. Kenneth Martin, a family and real estate lawyer in Moncton, noted that sometimes the tax deduction for those older than 65 (Line 301 on an income tax return) and other breaks, such as pension income-tax deductions, can go toward compensating for the capital gains hit.
"Who cares about the capital gains? Those deductions may reduce or get rid of most of the gains," Mr. Martin said. "So, it depends on your situation."