In the final post of my three-part blog series on transferring the family cottage, I discuss some of the alternative strategies available to mitigate or defer income taxes that may arise upon the transfer of the cottage to your children. Unfortunately, none provide a tax "magic bullet".
The following alternatives may be available to mitigate and defer the income taxes that may arise on the transfer of a family cottage.
Life Insurance
Life insurance may prevent a forced sale of a family cottage where there is a large income tax liability upon the death of a parent, and the estate does not have sufficient liquid assets to cover the income tax liability. The downside to insurance is the cost over the years, which can be substantial. In addition, since the value of the cottage may rise over the years, it may be problematic to have the proper amount of life insurance in place (although you can over-insure initially or if your health permits, increase the insurance at a later date). I would suggest very few people imagined the quantum of the capital gains they would have on their cottages when they initially purchased them, so guessing at the adequate amount of life insurance required is difficult at best.
Gift or Sale to Your Children
As discussed in Part 2, this option is challenging as it will create a deemed capital gain, and will result in an immediate income tax liability in the year of transfer if there is an inherent capital gain on the cottage. The upside to this strategy is that if the gift or sale is undertaken at a time when there is only a small unrealized capital gain and the cottage increases in value after the transfer, most of the income tax liability is passed on to the second generation. This strategy does not eliminate the income tax issue; rather it defers it, which in turn can create even a larger income tax liability for the next generation. Since many cottages have already increased substantially in value, a current sale or transfer to your children will create significant deemed capital gains, making this strategy problematic in many cases.
If you decide to sell the cottage to your children, the Income Tax Act provides for a five-year capital gains reserve, and thus consideration should be given to having the terms of repayment spread out over at least five years.
Transfer to a Trust
A transfer of a cottage to a trust generally results in a deemed capital gain at the time of transfer. An insidious feature of a family trust is that while the trust may be able to claim the Principal Residence Exemption ("PRE"), in doing so, it can effectively preclude the beneficiaries (typically the children) of the trust from claiming the PRE on their own city homes for the period the trust designates the cottage as a principal residence.
This paragraph is an update to the original 2011 post. A reader of the blog recently asked a question on life and remainder interests in a cottage. When gifting or using a trust, you can transfer ownership of your cottage to your children, while still keeping a "life interest" in the cottage, which allows you continued use of the cottage and the income from the property (if any) for the rest of your life. However, the transfer/gift to the trust still triggers a capital gain for tax purposes. You are essentially just ensuring you have access and use of your cottage and the future increase in the cottage value accrues to your children from the date of the transfer. This is a complicated topic and beyond my area of expertise. You should consult your lawyer in tandem with your accountant to ensure you understand the issues in your specific situation in using a life transfer and remainder interest.
If a parent is 65 years old or older, transferring the cottage to an Alter Ego Trust or a Joint Partner Trust is another alternative. These trusts are more effective than a standard trust, since there is no deemed disposition and no capital gain is created on the transfer. The downside is that upon the death of the parent, the cottage is deemed to be sold and any capital gain is taxed at the highest personal income tax rate, which could result in even more income tax owing.
The use of a trust can be an effective means of sheltering the cottage from probate taxes. Caution is advised if you are considering a non-Alter Ego or Joint Partner Trust, as on the 21-year anniversary date of the creation of the trust, the cottage must either be transferred to a beneficiary (should be tax-free), or the trust must pay income taxes on the property’s accrued gain.
Transfer to a Corporation
A cottage can be transferred to a corporation on a tax-free basis using the rollover provisions of the Income Tax Act. This would avoid the deemed capital gain issue upon transfer. However, subsequent to the transfer the parents would own shares in the corporation that would result in a deemed disposition (and most likely a capital gain) upon the death of the last surviving parent. An “estate freeze” can be undertaken concurrently, which would fix the parent’s income tax liability at death and allow future growth to accrue to the children; however, that is a topic for another time.
In addition, holding a cottage in a corporation will result in a taxable benefit for personal use and will eliminate any chance of claiming the PRE on the cottage for the parent and children in the future so this alternative is rarely used.
In summary, where there is a large unrealized capital gain on a family cottage, there will be no income tax panacea. However, one of the alternatives noted above may assist in mitigating the income tax issue and allow for the orderly transfer of the property.
I strongly encourage you to seek professional advice when dealing with this issue. There are numerous pitfalls and issues as noted above, and the advice above is general in nature and should not be relied upon for specific circumstances.
This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.
Part 3 – Ways to Reduce the Tax Hit
The following alternatives may be available to mitigate and defer the income taxes that may arise on the transfer of a family cottage.
Life Insurance
Life insurance may prevent a forced sale of a family cottage where there is a large income tax liability upon the death of a parent, and the estate does not have sufficient liquid assets to cover the income tax liability. The downside to insurance is the cost over the years, which can be substantial. In addition, since the value of the cottage may rise over the years, it may be problematic to have the proper amount of life insurance in place (although you can over-insure initially or if your health permits, increase the insurance at a later date). I would suggest very few people imagined the quantum of the capital gains they would have on their cottages when they initially purchased them, so guessing at the adequate amount of life insurance required is difficult at best.
Gift or Sale to Your Children
As discussed in Part 2, this option is challenging as it will create a deemed capital gain, and will result in an immediate income tax liability in the year of transfer if there is an inherent capital gain on the cottage. The upside to this strategy is that if the gift or sale is undertaken at a time when there is only a small unrealized capital gain and the cottage increases in value after the transfer, most of the income tax liability is passed on to the second generation. This strategy does not eliminate the income tax issue; rather it defers it, which in turn can create even a larger income tax liability for the next generation. Since many cottages have already increased substantially in value, a current sale or transfer to your children will create significant deemed capital gains, making this strategy problematic in many cases.
If you decide to sell the cottage to your children, the Income Tax Act provides for a five-year capital gains reserve, and thus consideration should be given to having the terms of repayment spread out over at least five years.
Transfer to a Trust
A transfer of a cottage to a trust generally results in a deemed capital gain at the time of transfer. An insidious feature of a family trust is that while the trust may be able to claim the Principal Residence Exemption ("PRE"), in doing so, it can effectively preclude the beneficiaries (typically the children) of the trust from claiming the PRE on their own city homes for the period the trust designates the cottage as a principal residence.
This paragraph is an update to the original 2011 post. A reader of the blog recently asked a question on life and remainder interests in a cottage. When gifting or using a trust, you can transfer ownership of your cottage to your children, while still keeping a "life interest" in the cottage, which allows you continued use of the cottage and the income from the property (if any) for the rest of your life. However, the transfer/gift to the trust still triggers a capital gain for tax purposes. You are essentially just ensuring you have access and use of your cottage and the future increase in the cottage value accrues to your children from the date of the transfer. This is a complicated topic and beyond my area of expertise. You should consult your lawyer in tandem with your accountant to ensure you understand the issues in your specific situation in using a life transfer and remainder interest.
If a parent is 65 years old or older, transferring the cottage to an Alter Ego Trust or a Joint Partner Trust is another alternative. These trusts are more effective than a standard trust, since there is no deemed disposition and no capital gain is created on the transfer. The downside is that upon the death of the parent, the cottage is deemed to be sold and any capital gain is taxed at the highest personal income tax rate, which could result in even more income tax owing.
The use of a trust can be an effective means of sheltering the cottage from probate taxes. Caution is advised if you are considering a non-Alter Ego or Joint Partner Trust, as on the 21-year anniversary date of the creation of the trust, the cottage must either be transferred to a beneficiary (should be tax-free), or the trust must pay income taxes on the property’s accrued gain.
Transfer to a Corporation
A cottage can be transferred to a corporation on a tax-free basis using the rollover provisions of the Income Tax Act. This would avoid the deemed capital gain issue upon transfer. However, subsequent to the transfer the parents would own shares in the corporation that would result in a deemed disposition (and most likely a capital gain) upon the death of the last surviving parent. An “estate freeze” can be undertaken concurrently, which would fix the parent’s income tax liability at death and allow future growth to accrue to the children; however, that is a topic for another time.
In addition, holding a cottage in a corporation will result in a taxable benefit for personal use and will eliminate any chance of claiming the PRE on the cottage for the parent and children in the future so this alternative is rarely used.
In summary, where there is a large unrealized capital gain on a family cottage, there will be no income tax panacea. However, one of the alternatives noted above may assist in mitigating the income tax issue and allow for the orderly transfer of the property.
I strongly encourage you to seek professional advice when dealing with this issue. There are numerous pitfalls and issues as noted above, and the advice above is general in nature and should not be relied upon for specific circumstances.
This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.
