We want to hand down the family cottage. What do we need to know about capital-gains tax?

Q: Our family inherited a cottage. We want to keep it and hand it down to the next generation, but are concerned about the impact of a capital-gains tax on our finances. What are our options?

We asked Jennifer Watson, managing partner at Watson Investments and portfolio manager at Watson Securities of Aligned Capital Partners, to answer this one.

There are a number of considerations when it comes to financial planning around a family cottage. Ms. Watson broke down the key concerns and points to remember.

“None of this happens in isolation,” she said. “The right mix depends on your full financial picture, best mapped with a wealth manager.”

How your cottage is taxed

The tax generally hits when the cottage is sold, or the last owner dies. According to the CRA, the law assumes you sold all your capital property at fair market value immediately before you passed away. “Fifty per cent of the gain – value minus cost, plus documented improvements – lands on the final tax return,” Ms. Watson said.

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It’s important to note that, although the estate pays the tax first, if cash is short, the executor may need to sell something, sometimes the cottage, unless heirs cover the gap, she said. Once settled, the cost base resets to today’s value, so the next generation’s gain starts fresh.

Tracking capital improvements

Keep every receipt for capital work: a new roof, dock, septic system, everything, in a file heirs can find easily. Each bit of work raises the cost base and lowers the eventual tax bill at your death.

Optimizing the principal residence exemption

In Canada, the principal residence exemption allows homeowners to steer clear of or reduce the tax they would pay on the profit made from selling their home. It is based on the total years a property is designated as your principal residence compared to the total years you owned it. The CRA defines a principal residence as somewhere you have “ordinarily inhabited.” So even a short period of time can qualify – as long as you have not designated another home as principal in the same year.

“The principal residence exemption isn’t decided year by year,” Ms. Watson said, “it’s assigned retroactively at sale, to whichever years benefit you most.” If the cottage has gained more value than your other home, you can designate the cottage, not the house, as your principal residence for its strongest years.

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Using trusts and holding companies

Both trusts and holding companies come up in cottage planning but they are rarely the best fit in this scenario, Ms. Watson said. A trust faces a deemed disposition every 21 years, where the CRA considers the property was sold at fair market value even if no sale took place. “A holding company forfeits the principal residence exemption entirely,” she said.

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Consider joint ownership on the title

According to Ms. Watson, whose name is on the title won’t change the first-death tax outcome – where the surviving spouse automatically inherits any property and assets tax-free, deferring the capital-gains tax to the second death.

However, it affects whether the estate will go through probate, a legal process that validates a deceased person’s will.

“Joint ownership passes straight to the survivor outside the estate, while sole ownership must go through probate which will incur a cost,” she said. It’s worth noting that, since 1982, spouses – including common-law partners – count as one household for the principal residence exemption, which means that you can’t shelter two properties by splitting the names on title.

Deferring capital gains at death

If the person or persons who you name as inheritors of the cottage want to use it during their lifetime, then subsequently have the cottage go to their adult children, they could put it in their own adult kids’ names when they inherit it, rather than leaving it to them later, when the property’s value could have increased. They become joint tenants and can have a lawyer draft a document that states they have the right to lifetime use of the property, even though it’s legally in the kids’ names.

“However, that can have other implications … and pushes off the tax and future capital gains essentially two generations, creating an even larger tax bill on your children’s death to their heirs,” said Ms. Watson.

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The risk, she added, is that there can be many owners. So if one person experiences divorce or bad credit, it will have an impact on anything related to the cottage. The bright side, she added, is that it allows the person or persons who inherited the cottage to enjoy it along with their children before a large capital gain would happen. “Speaking to a wealth manager and a lawyer to work this out can make this option possible, depending on the person’s main goals.”

Do you want advice on a financial planning or retirement issue that’s affecting you? Send us an e-mail.