Cottage Succession: Tax Implications and Smart Strategies – Part 2

As discussed in Cottage Succession: Planning, Options & Key Considerations  Part 1 , deciding the fate of your cottage – whether to sell, leave to a loved one, or gift to a charity is not an easy one. The emotional, financial, and logistical implications can be significant, and each option has its own complexities. Whether you decide to leave the cottage to your family, sell it, or make a charitable donation, it’s essential to understand the tax consequences. By planning ahead, you can ensure that both your estate and your loved ones are prepared, helping to mitigate the financial burden and ease the transition for everyone involved. 

Understanding Cottage Succession: Important Definitions

What Is Deemed Disposition?

• Deemed disposition refers to the assumption made by the Canadian Revenue Agency (CRA) that, just prior to person’s death, they sold all of their property at a fair-market value. That means that any appreciation in the value of the property over the years is recognized and subject to tax. If there is an increase in value, this will be treated as a capital gain and taxed on your Final Return [1].
• However, in Canada, capital losses on personal-use property, including cottages, are generally not deductible. If your cottage has depreciated in value, the capital losses on this land cannot be applied to your Final Return as it is not considered to be a revenue-generating asset. That said, losses can be applied to vacant land [2]. 
  
  

What is a Final Return?

• The Final Return is the income tax return of a deceased person’s estate for the year of their death. It must be submitted 6 months after the date of death and include all income earned from January 1st to the date of death, including any capital gains from the deemed disposition of assets [3].
• Any taxes owed, including capital gains taxes on the appreciated value of an asset such as a cottage, must be settled by the estate before assets can be distributed to beneficiaries. Some strategies to mitigate capital gains taxes are discussed later in this article [3].
  
  

What is Capital Gain Tax?

• Capital gains tax is paid on the profit made by selling an asset such as a cottage if the sale price is greater than the original purchase price. The taxable portion of the gain is determined by the inclusion rate. 
  
  

Options and Implications in Cottage Succession

Leaving the Cottage to a Spouse or Common-Law Partner 

• Capital Gains Tax:
  • If upon your passing, a property is transferred to a surviving spouse or common-law partner (who is a resident of Canada at the time) capital gains tax may not apply to the Final Return. However, for this to be applicable, the beneficiary must have “locked-in” rights, meaning they must have the right to absolute ownership of the property no later than 36-months after the death of their spouse. Additionally, during the life of the surviving spouse, no person can obtain use of any of the capital or income generated by the property or trust. If these criteria are met, the transfer of the property will occur on a tax-deferred basis meaning that capital gains or capital losses will not be triggered until the spouse sells or is deemed to sell the property [1]. 
    
    

Leaving the Cottage to Your Offspring or Other Beneficiary 

• Capital Gains Tax:
  • Upon your death, your cottage is deemed to have been sold at fair market value, triggering capital gains tax on the appreciated value since its original purchase. This tax liability becomes part of your estate and may need to be settled before the property can be transferred to your heirs [2]. 
  • However, if your cottage is your principal residence, some or all of the capital gains tax may be exempted. Learn more here on the conditions that must be met for a property to be considered a principle residence. Also note that the amount of land that can be designated as a principal residence is limited to 1.24 acres unless it can be proven that more land was necessary for the property to fulfill its function as a residence [2]. 
  • If your beneficiary chooses to sell the property after the distribution of the estate, capital gains on the sale of the property will be calculated as the difference between the selling price and fair market value at the time of your death, with the cost related to the sale deducted [2]. 
    
    
• Probate Fees:
  • In Ontario, assets passing through your estate are subject to probate fees, which are calculated based on the estate's value. This can add to the cost of transferring the cottage to your children [4]. 
    
    
• Estate Liquidity:
  • If the capital gains tax and probate fees are substantial and cannot be covered by your estate, your heirs might need to sell the cottage to cover these costs, potentially leading to the loss of a cherished family asset. Ensuring there are sufficient funds in the estate or implementing other strategies to manage these liabilities is essential for preserving your legacy.
    
    

Donating the Cottage to a Charity

• Capital Gains Tax:
  • Donating appreciated property, like a cottage, to a registered charity can eliminate capital gains tax on the appreciated value. This means that any increase in the property’s value since you acquired it will not be subject to tax. However, to benefit from this exception, the donation must be made directly to the charity, and the property must be transferred at fair market value [2].
    
    
• Tax Receipt:
  • When you donate your cottage, you will receive a charitable donation receipt for the fair market value of the cottage. This receipt can then be used to offset other taxable income, subject to certain limits of course. Generally, you can claim up to 75% of your net income for the year. If your donation exceeds this limit, the unused portion can be carried forward and claimed on your tax return for the next 5 years [2]. 
    
    
• Viability of the Charitable Organization:
  • Ensure that the charity is a registered organization with the CRA and that they are willing and able to accept the property. Some charities may not have the resources to manage real estate donations. Also, consider how the donation aligns with your philanthropic goals and if it makes sense for your estate planning [2]. 
    
    

Selling the Cottage

• Capital Gains Tax:
  • A key consideration in selling your cottage is the capital gains tax that will be owed on the profit. The exact amount owed will depend on the sale price, adjusted cost base (which includes the original purchase price and qualifying improvements), and your personal tax situation. Ensure proper planning to manage and potentially reduce this tax burden.
    
    
• Tax Planning:
  • To help ease the tax burden for your loved ones, you might consider selling the cottage during your lifetime. This allows you to declare the capital gain in a year when your marginal tax rate might be lower. Additionally, you can spread the tax liability over five years using a capital gains reserve if you receive a promissory note or mortgage from the buyer.
    
    
• Estate Liquidity:
  • Selling the cottage provides immediate liquidity, which can be used to fund retirement, pay off debts, or cover other expenses. Alternatively, the proceeds can be distributed among heirs. This option may help avoid potential liquidity issues in the estate and provide your heirs with the financial resources they need sooner. This will also eliminate the probate fees that would otherwise occur.
    
    

Strategies to Mitigate Tax Implications

• Inter-Vivos Trust:
  • Transferring the cottage to a trust during your lifetime can help manage capital gains tax and avoid probate fees. However, there may be tax implications at the time of transfer, and the trust will need to be managed according to its terms.
    
    
• Joint Ownership:
  • Adding your children as joint owners can facilitate a smoother transfer and may reduce probate fees. However, this approach requires careful consideration of control and decision-making regarding the property.
    
    
• Undivided Interests:
  • Transferring undivided interests in the cottage over several years can spread the capital gains tax liability, potentially reducing the overall tax burden.
    
    

At The Crossroads of Cottage Succession: Discussions & Decisions  

Ontario cottage country families have been passing down their legacy for generations. But is this the right path for you and your heirs? As we discussed in Cottage Succession: Planning, Options & Key Considerations - Part 1, the landscape has changed and the realities of today make cottage succession a complex decision. When in doubt talking openly and honestly with your family and consulting with experts helps you make informed decisions. 

Consult With Professionals:

• Engage with your tax advisor, accountant or estate planner to understand the full implications of each option based on your specific circumstances.
  
  

Communicate With Family:

• If you know (or think) your children would like the cottage to be left to them it’s worth the discussion. Ensure they are prepared for the responsibilities and potential costs associated with inheriting the cottage.
  
  

Consider Long-Term Goals:

• Align your decision with your financial goals, family dynamics, and the legacy you envision.
  
  
  

Selling – Key Considerations When Listing Your Cottage for Sale 

Whether you are in the initial stages of estate planning or if you have determined it is in your best interest to sell the cottage, speak with an experienced real estate agent. 

Comprised of some of the best agents in Muskoka and across central Ontario, The Janssen Group has worked with families and estates for over 30 years. They fully understand current market conditions and can advise on the best time to list the cottage for sale, discuss options with you and provide the pros and cons of listing publicly or exclusively. Contact The Janssen Group today.