Passing down the family cottage

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 value of your property has increased significantly, your estate might have to pay a substantial capital gains tax, which could reduce the amount of money that you intend to leave to your heirs or, in some cases, force the sale of the property to cover the tax liability.

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 one of the most cost-effective ways to help manage capital gains tax implications. A permanent life insurance policy can be purchased with coverage amounting to the potential tax liability of the family cottage. When you pass away, your beneficiaries can use the tax-free death benefit to help pay the taxes owed, allowing them to keep the 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. In this scenario, the children’s cash payment will be equal to the taxes payable by you on the sale, however the difference between the fair market value of the property (i.e. the transfer value) and the cash payment would be settled by issuing the promissory note. This promissory note would not be collected upon, and in your will, this note would be forgiven. 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.

Passing down the family cottage

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