For many families, a summer or winter home or cottage is one of their most treasured assets. Most cottage owners want the cottage to stay in the family for generations. However, this requires significant thought and planning. Families need to know that legal costs and family disputes come with poorly managed cottage succession. This article identifies common problems and some solutions for passing on the cottage. It is not meant to be exhaustive. Legal advice should be sought so that the particular circumstances of each family and cottage can be considered.
To begin, we suggest that families consider the "what if" questions regarding the cottage and the next generation. For example, what if only one child wants the cottage, but cannot afford to buy out the other children? What if a child or children cannot afford the upkeep? What if some children live or move too far to use the cottage? What happens if a child has a divorce or bankruptcy or dies? What if the children disagree about need for repairs or renovations or housekeeping standards? And what if one child does not play by the rules? Also consider, what happens if one child is a U.S. person?1
We recommend starting the succession conversation early. The next generation may lack the desire or capacity to share ownership, especially when they understand the costs and responsibilities which will no longer be borne by the parents. If everyone thinks it is possible and desirable to keep the cottage in the family, there are strategies to address the financial and legal barriers.
Minimize capital gains tax
The federal capital gains tax is a major hurdle to passing on a family cottage. It can result in a large tax bill or even double taxation. If the cottage is given to children during the parent's lifetime or on death or perhaps sold to children at a discounted rate, the government views it as having been sold at fair market value. The parents will pay capital gains taxes on the difference between the fair market value and the adjusted cost base, which is the value of the cottage when the parents bought it plus any capital improvement expenses (e.g., renovations).
One way to minimize capital gains tax is by transferring an undivided interest in the cottage to the children over several years. This way taxes are only paid on the portion transferred each year and the tax bill can be spread out over several years, hopefully at a lower tax rate than if transferred in its entirety in one year.
For some owners, another way to limit capital gains tax is to designate the cottage as the parents' principal residence to take advantage of the principal residence exemption for capital gains. Each couple can designate one principal residence at a time, which need not be where they live full time. If the value of the cottage has increased more than their home, it may be advantageous for the parents to designate the cottage as their principal residence for some or all the years of ownership.
Capital gains tax can cause double taxation in the next generation. If the parents sell the cottage to the children for less than fair market value, the parents will still pay tax on the fair market value, not the discounted value. Then when the children sell the cottage they will pay capital gains tax on the difference between their sale price and the discounted price they bought it for – even though the parents have already paid tax on the difference between the discounted price to the children and the fair market value at the time they transferred the cottage.
There is a way to avoid this double taxation. The parents can sell the cottage at full market value to the children and take a promissory note from the children for the amount they wish to discount, then forgive the promissory note on death.
Consider probate fees
If the parents leave the cottage in the will of the last to die, rather than transferring it during their lifetime, then in some provinces the estate of the last to die will pay probate fees on the value of the cottage.
As a preliminary point, the parents should be holding the cottage in joint tenancy to avoid probate fees at the death of the first to die. Otherwise, if the cottage is in one name alone, the surviving parent will have to pay probate fees at the death of the first to die. These can be significant. For example, probate fees on a cottage worth $1,000,000 would be $14,000 in British Columbia or, subject to certain exceptions, $15,000 in Ontario.
In the worst-case scenario, if the cottage is in one parent's name alone, in order for the other parent to inherit the cottage, they will have to pay the probate fees. When that parent dies, probate fees will be payable again on the cottage before it can go to the children.
Consider property transfer tax
Some provinces have property transfer tax or fees which are payable on the transfer of a cottage. In some provinces, for example, British Columbia, this tax is significant. It will apply on any transfer, whether during the lifetime of the parents or on death, and whether on sale to a child or gift. There may also be additional property transfer tax if the child is not a Canadian or permanent resident.
Consider a trust
Transferring the cottage to a trust during the parents' lifetime can help save the legal fees related to probate and probate fees.
Putting the cottage in trust can give the parents time to make a decision about succession and to test how the children share management. A trust may allow more flexibility with respect to distribution of the cottage – a trust provides flexibility to give the cottage to only the children who want it and who agree to shared ownership rules.
There are disadvantages however. Transferring the cottage to a trust will trigger capital gains tax unless the parents are over 65. Property transfer tax may be payable as well. Trusts also have some administrative limitations – capital gains tax is triggered on the 21st anniversary of the trust's creation and at that time the cottage would have to be transferred to a Canadian resident child or children in order to avoid that tax (or back to the parents if they are still alive). This puts the family back in the same place as previously. There are also complexities if the parents wish to use the principal residence exemption for the cottage.
Consider a mortgage or life insurance
If money is tight for the children, a mortgage or life insurance may help. The children could take out a mortgage to pay the taxes, property transfer tax or purchase cost of the cottage. Mortgage payments may be an affordable alternative to investing in city real estate, and the children could designate the cottage as their primary residence, reducing future capital gains tax.
The parents could also take out life insurance, payable on death, to cover capital gains tax and property transfer tax. The beneficiaries (the children) could pay the insurance premiums. The cost of life insurance will depend on the parents' health, but will often be lower than the tax.
If some children do not wish to own the cottage, life insurance could also help equalize inheritance. These children could be made the beneficiary of the parents' life insurance, while other children receive the cottage instead.
Consider a co-ownership agreement
If several children want to share the cottage, co-ownership agreements can be highly customized to the family's preferences. The children could agree to terms about cost-sharing, times and ways to use the property, need for repairs and renovation, restrictions for non-family members or non-blood relations, when the agreement will end, and enforcement of these terms.
Parents might ask the next generation to draft a cottage agreement among themselves. This can show whether the children have a shared vision and can accommodate each other's goals for the cottage. Later, you may want a lawyer to make sure you have considered all of the risks and opportunities.
Consider whether the children will hold the cottage as joint tenants or tenants in common
This is an important question. If the children hold as joint tenants, then at the death of a child, the surviving children own the cottage. However, if the value of the cottage increases during the time it is owned by the deceased child, that capital gain will be taxable but the tax is payable by the child's estate and not by the surviving children who now own the cottage.
If the children hold as tenants in common, then at the death of a child, that child's share forms part of that child's estate and will be distributed as set out in the child's will (or if there is no will, on intestacy of that child). This means the ownership and any capital gains tax will be in the child's estate. However, the surviving children will end up owning the cottage with the beneficiaries of the deceased child's estate – which may be a spouse or children or a stranger.
This question should be discussed amongst the family members as everyone should know what will happen on the death of a child.
Passing on the family cottage can be costly, legally complex, and emotionally taxing. If the family wants to keep the cottage, speaking to a lawyer about the options described above to save money, minimize risk, and safeguard family relationships, is advised so that the good memories can keep growing for generations.
1. If one of the children is a U.S. person, there will be a need to consider the impact of U.S. income tax and estate tax. A discussion of these considerations goes beyond the scope of this article.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.