Estate planning insights: The cottage conundrum

Summer 2014

Take a coveted family asset, attach great emotional significance, stir in some sibling rivalry and let simmer until it boils over. Even with the best of intentions, passing on a beloved property can be a recipe for a toxic stew that threatens to poison family relationships. Fortunately, with prudent planning, it doesn’t have to be that way.

A legacy property, such as a cottage, condo, country home or beach house, plays a powerful role in a family’s mythology. These are the places where memories are made, milestones are passed, vacations are taken and holidays are celebrated. In contrast to life at home, the pace there is usually more relaxed, free from the pressures of everyday work and school, and the focus almost always is on fun. Who wouldn’t want these good times to go on forever? But leaving these properties to the next generation can be fraught with complications that can both undermine your intentions and erode all those good memories.

Be realistic and reasonable

Before you spend time and money figuring out how to best transfer a property to your children, you need to ask some tough questions – questions that you may not like the answers to. Do your children actually want the property? Will they use it and can they afford it? Is sharing the ownership likely to cause problems between siblings? What’s important is not to delude yourself or make assumptions. Instead, you want to be realistic when assessing the situation. As Sam Chinniah, Senior Vice President at T.E. Wealth, points out, “You aren’t just dealing with your children. Their spouses and children also need to be considered.” Proximity to the property is also a factor; if some children live far away it may impair their ability to use the property. In addition, each child’s capacity to contribute to the upkeep and enhancement of the property may not be equal and this can become a sore point. If your children (or their families) don’t get along now, how likely will they cooperate as joint owners?

While some families do manage to make the transfer work, in Sam’s experience that is the exception and not the rule. He recommends that parents transfer the property to one child, planning for the others to receive an equal amount in their inheritance. As far as deciding which child gets the property, Sam has seen different strategies be effective. “If one child has always helped out, give them first right of refusal to acquire the property through your estate at fair market value. Alternatively, if you don’t want to choose, have each child make a closed bid for the property, assigning the property to the child making the highest bid.” No matter how you decide, Sam stresses that the process must be open and transparent to avoid any misunderstandings and hard feelings.

Communicate, communicate, communicate

Terry Willis, Vice President at T.E. Wealth, concurs. “You have to have the conversation to find out who wants the property first. This is what will drive the rest of your planning. If no one wants the property, your planning options are relatively straightforward. But if one or more children are interested, you have a number of options to consider,” explains Terry. And if people’s interest changes over time, perhaps a child moves too far away to use the property, you need to keep everyone informed.

When all children want to share ownership, consider documenting how the shared arrangement will work, including handling expenses and divvying up the vacation weeks. Placing the cottage in a trust, either while you are living or through your Will, is one way to ensure these arrangements are respected. If ownership will be unequal among your kids, you can take steps through your Will to equalize the monetary value of their inheritances.

Consider the tax issues

Because vacation properties are usually not principal residences, any appreciation in value will attract capital gains tax when the property is sold. Whenever you are considering transferring ownership, either during your lifetime or through your estate at death, the effect of tax needs to be considered. In many cases the resulting tax can be substantial because the property has grown significantly in value. If you have maintained good records of property improvements, these expenses can increase the cost base of the property and reduce the net capital gain.

While you are living

There’s no escaping tax by selling your property to the kids for a nominal amount or giving it as a gift. The government will calculate the tax as if the property was sold at fair market value. You can sell the property to your kids and take back a demand mortgage with payments deferred, arranging for the debt to be forgiven through your Will. Under this arrangement your children will never pay the mortgage and therefore never pay for the cottage. Although you will still pay the capital gains tax, you will be allowed to spread the payment over five years. Alternatively, you can place the property in an Inter Vivos trust, pay the capital gains tax upon transfer and keep future capital gains, which are realized every 21 years, in check for your heirs. Whatever route you decide to take, be sure you know where the money will come from to cover the tax.

At your death

The property, unless it can be transferred to a surviving spouse, will be deemed disposed at your death and your estate will be required to pay the resulting tax, possibly reducing the inheritances available for other heirs. You, or your children, can purchase life insurance for an amount that will cover the tax liability at the second death of you and your spouse.

Special concerns for U.S. and other non-Canadian properties

The condo on the golf course in Arizona or the villa in the south of France comes with estate planning complications. U.S. property, when your worldwide assets surpass $5.34 million* for a couple, can trigger U.S. estate tax. Furthermore, individual states (and other countries as well) have their own rules for what constitutes a valid Will, and, as a result, your Canadian Will must pass scrutiny in the jurisdiction where you own the property. In addition, there may be probate, capital gains and creditor and divorce protection issues to consider. All of this further complicates the settling of your estate and can escalate both the time and expense of getting your assets distributed to your heirs. To remove some of the roadblocks, Sam recommends having a valid Will to deal with the property (and any other local assets) in the jurisdiction where the property is located. A Cross Border Trust can be helpful in eliminating many of the issues related to leaving U.S. property but this must be set up before you die. Another option, the Beneficiary Deed, is available in some states and works like the beneficiary designations on your RRSP and life insurance, bypassing your estate and probate.

In the end, apply common sense

On a cost/benefit basis, your best option may be to sell the vacation property before you die. “If your children are lukewarm to the idea of owning the property, why put all this effort and expense into passing the property on?” asks Terry Willis. And even when your children want the property, he recommends using common sense before complicating your estate or setting up costly trust arrangements.

Sam Chinniah suggests transferring ownership while you are living and pay the capital gains tax so that your children aren’t fighting over the property later. “If your objective is to preserve all of the good memories, this is one way to do it.”

*The American Taxpayer Relief Act of 2012 permits an exemption of $5 million, indexed annually to inflation. For 2014, the exemption is $5.34 million.

How T.E. Wealth can help

• Help you identify issues and quantify the tax liability associated with vacation properties.

• Facilitate a family meeting to determine what to do with the property.

• Work with your lawyer and accountant to design an effective strategy for transferring property.

• Offer in-house cross border expertise as well as a U.S. affiliate to provide referrals to legal and accounting professionals in the jurisdiction where your U.S. property is located.

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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