1. Capital Gains Taxes Taxation issues lie at the root of many cottage bequest problems.  The biggest issue that that capital gains taxes must be paid when the cottage is sold or gifted, either during the parents lifetime or after their death. Estimate the capital tax payable a. What is the fair market value today? Start by figuring out the present fair market value (FMV) of the cottage. Check recent sales in the area, ask a realtor for an opinion of value, or pay for an appraisal. What is the cost base? b. Find the cost base of the cottage. If you acquired the cottage after 1971, the value as of the date of acquisition is the cost base. If you acquired it before 1971, then the value as of December 31, 1971, is the relevant amount. If you cannot get this value by yourself, appraisers can research comparable sales. c. How many capital improvements? Next, add up the capital improvements made to the cottage or the property since you acquired it. This would include new docks or additions, replacing the roof or windows, installing a new well or pump. You can’t include simple repairs, maintenance or the value of your own hard work in improving the cottage, only the amount actually paid to others. d. What is the adjusted cost base? Now add the cost base and the capital improvements. This will produce the adjusted cost base (ACB). (If you made use of the capital gains tax exemption before it was taken away in 1994, then you can get the ACB from the tax return in 1994. The process above still applies, but from 1994 instead of from the date of acquisition.) e. What is the total capital gain? Subtract the Adjusted Cost Base from the Fair Market Value. This gives you the total capital gain. f. What is the tax payable? Divide the capital gain figure by half to get the taxable capital gain, then again by half to approximate the tax actually payable. Take steps to reduce the capital gains tax payable

• Transfer it to children  in stages rather than all at once (i.e. 20% a year for five years) to reduce capital gains taxes payable  (and also prevent a possible clawback in OAS)

• Transferring it via your will may result a higher total amount of capital gains payable, but there may be more sources of payment available

• Use the principal residence exemption (you can choose to designate your cottage instead of your house as a principal residence for a specified period). You and your spouse are able to claim only one principal residence per tax year.  You don’t need to identify a principal residence until the residence is sold or ownership is otherwise transferred.  This means the designation can be applied in hindsight, by reviewing the history of the changes in the value of the principal residence and cottage and moving it between them for particular years to minimize the capital gains impact.  This can be done as part of settling an estate or when selling a property.

Determine how to fund the capital gains tax liability

• Savings and investments
• Life insurance (adult children can pay premiums)
• Have the beneficiary children pay the capital gains taxes triggered on inter vivos transfers
• Use the cottage itself to fund the capital gains tax (subdivide and sell a lot; register a mortgage that the children can pay off over time)

Ongoing Management: the Use, Operation and Expenses of the Cottage How will the children use, operate and fund the expenses of the cottage? Among the questions to be answered are:

• Can any child use the cottage any time, or will there be periods of exclusive use?
• Who will open and close the cottage?
• Who makes sure the bills are paid?
• Who is responsible to pay the bills, whether it’s replacing the septic system, paying the municipal taxes or repairing the roof.  How do you deal with differing financial resources of the children?
• Who decides if improvements or additions are to be made?
• If a child dies, does his or share of the cottage pass to the spouse and children, or does ownership continue with the surviving siblings only?
• What happens if a child divorces or goes bankrupt?
• What happens if one or more of the children wants to sell?
• What happens if the children stop getting along and/or reach an impass?

A Co-Ownership Agreement, negotiated while the parents are alive and able to assist, can be invaluable in retaining family harmony and enabling successful second- and third-generation ownership. A Co-Ownership Agreement is essentially a business partnership agreement. Some issues addressed are identical, like decision-making procedures and disposition of interests by the partners. Other matters are unique to cottages and your own family’s needs and desires. Vehicles to Transfer the Cottage to the Next Generation: Retain Sole/Joint Ownership by Parents & Transfer Via Will

• Best for simple succession situations
• Pros: wills are simple and inexpensive to create; parents retain ownership and control during their lifetime
• Probate fees (approximately 1.4%) will be payable on the assessed or market value of the cottage
• Capital gains taxes will be payable on death
• How to deal differences in children’s incomes and financial resources: leave a certain sum of capital in trust in your wills to be used exclusively for cottage purposes ( referred to as a testamentary trust).   It enables all or a significant portion of the cottage operating costs to be paid from the trust, rather than from the childrens’ own pockets. Furthermore, if there is a need for a substantial expenditure, then the trust capital can be encroached upon for that purpose, avoiding a financial emergency. The use of a testamentary trust compensates for the differences in economic positions between the children, to the benefit of all.

Inter Vivos Gift or Sale to Children

• Best if parents are ready to give up ownership and control of their cottage now
• Pros: no probate fees are payable; children can assume ownership costs and responsibilities; additional capital gains deferred to recipients
• Gifting is simply transferring an interest in the cottage without requiring payment.
• You cannot save on capital gains taxes by gifting. For tax purposes, the property is deemed to pass at fair market value. You must report the gift transfer on your next income tax return as a taxable disposition using the fair market value (FMV), even though you actually received no money. This is one of the impediments to cottage succession – even though the parent may choose to give the cottage away, the tax costs are the same as a real sale, and the parent does not have sale proceeds to pay the tax.
• Property Transfer Tax may be payable (1% on the first $200,000 and 2% on the remainder) of the assessed value, whether gifted or sold

When a related individual transfers a recreational residence , you may be exempt from paying PTT. The following people are considered to be a related individual:

• your spouse, child, grandchild, great-grandchild, parent, grandparent or great-grandparent,
• the spouse of your child, grandchild or great-grandchild, and
• the child, parent, grandparent or great-grandparent of your spouse.

Your spouse is:

• a person who you are married to, or
• a person who you are living and cohabitating with in a marriage-like relationship, provided that you have been living and cohabitating in that relationship for a continuous period of at least two years. This includes a marriage-like relationship between people of the same gender.

The following are examples of people who are not considered to be a related individual: your sister, brother, uncle, aunt, niece or nephew. A property is considered to be a recreational residence if the following four criteria are met. 1. Before the transfer, the person transferring the property to you (the transferor) usually resided on the property on a seasonal basis for recreational purposes. Please note: When a trustee is involved in a transfer, the trustee becomes the transferor and this requirement applies instead to the settlor or the deceased. 2. The property is classified as residential by BC Assessment. The property includes the land and any improvements on the land (e.g. buildings). 3. The land is 5 hectares (12.36 acres) or smaller. 4. The property has a fair market value of $275,000 or less.

• Consider retaining a life interest in the cottage, whether gifted or sold (can be registered on title to the cottage in the Land Title Office)
• A  life interest provides several advantages to the parents. One is that it entitles them to use the cottage for their lifetime as of right, not rely upon the continued goodwill of the child who now owns the cottage. Another is for the parents to retain a measure of control. With a life interest, the child cannot “cash in” on the cottage by selling it or mortgaging it, without the involvement and consent of the parents. This would defeat the intention of keeping the cottage for family purposes. If and when the parents are no longer interested in using the cottage, or are no longer concerned that a child may cash in on it, then the life interest can be released.

Transfer to a Trust

• Best if parents wish to leave the cottage to children without the costs of probate for their estate, but do not want to relinquish control
• A possible solution to leaving a vacation property to more than one family member is to transfer it to a trust.  In addition, a trust affords benefits such as creditor protection, the ability to defer capital gains taxes on capital assets and centralized asset management.

Multiple Beneficiaries, Centralized Management and Creditor Protection

• The trust can be structured to govern who is entitled to benefit from the property, how it is managed and what to do if the trustees can’t agree.
• The trustees of the trust could be one or more individuals who would have the power to make certain decisions, and the beneficiaries could include not only children, but potentially grandchildren or other relatives.  An advantage to a discretionary trust is that none of the beneficiaries have any vested right to the property – they will only be entitled to use the property as the trustees allow and/or when the trustees decide to distribute the property to them.  In the meantime, if a beneficiary dies, there will be no tax liability resulting from their interest in the trust.  If a beneficiary suffers a marriage breakdown or experiences creditor issues, they will have a strong argument that they have no interest in the vacation property, and that it therefore should not be subject to asset division or seizure.

Tax Considerations

• When an asset is transferred into a trust, the transfer will trigger a deemed disposition of any unrealized capital gains (except in the case of a spousal, alter ego or joint partner trust).  Once the property is transferred into a trust, it can grow in value in the trust and the death of a beneficiary will not trigger any tax liability.
• There will be a “deemed disposition” of the property held in the trust every 21 years thereafter.  This means that any unrealized capital gain in the value of the recreational property will be triggered on the 21st anniversary of the trust and the tax will have to be paid (unless the trust property is distributed to a successor trust or Canadian resident beneficiaries prior to the 21st anniversary).
• The property in the trust will not be subject to probate fees, currently approximately 1.4% of the gross value of the estate.

Primary Residence Capital Gains Exemption Issue The Income Tax Act allows a home owned by a “personal trust” to qualify as a principal residence if the recreational property was ordinarily inhabited in the calendar year ending in the relevant fiscal year of the trust by an individual beneficiary of the trust or a child, spouse or former spouse of such a beneficiary. A beneficiary who satisfies this test is referred to as a “specified beneficiary”. A personal trust is defined by subsection 248(1). Generally, a personal trust is either a testamentary trust or an inter vivos trust where all of the beneficiaries received their interests as gifts. In order to limit the types of taxpayers who can benefit from the principal residence exemption in respect of a home held through a trust, a number of limitations are placed on the ability of a personal trust to claim the benefit of the exemption. Pursuant to paragraph (c.1) of the definition of “principal residence” in section 54, a taxpayer that is a personal trust may designate a property as a principal residence if:

• the designation is made in the prescribed form and manner;
• each individual who in the calendar year ending in the taxation year, is beneficially interested in the trust and ordinarily inhabits the housing unit, or has a spouse, former spouse or child that ordinarily inhabits it, is listed in the designation;
• no corporation other than a registered charity or partnership is beneficially interested in the trust at any time in the year;
• no other property has been designated for the year as a principal residence by a specified beneficiary of the trust, by the beneficiary’s spouse (other than a spouse who was throughout the year living apart from and was separated pursuant to a judicial separation or written separation agreement from, the beneficiary), by a person who was the beneficiary’s child (other than a child who was during the year a married person or 18 years of age or over) or where the beneficiary was not during the year a married person or a person 18 years of age or over, by a person who was his or her mother or father, or his or her brother or sister who was not during the year a married person or a person 18 years of age or over.

The designation which must be filed by the trust must specify each individual who was a specified beneficiary of the trust in the calendar year ending in a relevant fiscal year of the trust. A designation by the trust is not valid if any of the following persons have designated any other property as their principal residence:

• a specified beneficiary of the trust;
• a spouse of a specified beneficiary unless the spouse is living apart from the specified beneficiary pursuant to a judicial separation or a written separation agreement;
• a child of the specified beneficiary unless the child is at least 18 years old or married;
• a parent of the specified beneficiary unless the specified beneficiary is either married or at least 18 years old; or
• a sibling of the specified beneficiary unless either the sibling or the specified beneficiary is either married or at least 18 years old.

**Note: A property which is validly designated as the principal residence of a trust is deemed to have been designated by every beneficiary of the trust as that person’s principal residence for the calendar year ending in the relevant fiscal year of the trust. This rule prevents the trust beneficiaries from designating any other property as their principal residence for the year. Transfer to a Family held Non-Profit Organization

• Best for those with a large cottage property suitable to being shared by an extended family
• Enables successive generations of family to use the cottage without incurring capital gains tax or probate fees
• Initial transfer will likely trigger a capital gain which in the case of a large property could be massive
• Demographics can force the sale of such compounds: too many members and too little space
• Expense of ongoing accounting and legal fees

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