From The Globe and Mail
Recreational Properties: SUCCESSION PLANNING
Squabbling among heirs and hefty tax bills can be avoided with proper planning, experts say
GAY ABBATE, June 6, 2008
Two brothers both loved the family cottage they inherited.
For one, the cottage was a tranquil escape from urban life, but his sibling used it as a place to party with his pals. The two uses simply did not mesh and led to so much dissension that they finally sold the cottage.
That scenario, or one similar to it, has led to the loss of many family cottages and hard feelings among siblings, says Peter Lillico, a lawyer in Peterborough, Ont., who specializes in cottage succession planning.
If the family wishes to preserve the cottage for several generations it is vital that parents map out the best strategy, not only to avoid squabbles after their death but to deal with the tax bite faced by their heirs, he says.
With cottage property skyrocketing in value in recent years, there are two key reasons to treat the cottage differently than the house and other assets.
One is the capital gains tax (CGT) that kicks in when a cottage is passed down – which could run into tens of thousands of dollars.
The taxes alone could force the sale of the cottage if they are beyond the financial means of the heirs, Mr. Lillico says.
“Your goal is to pass the cottage over to the children without bankrupting yourself or your estate.”
The other reason is the sentimentality associated with a family cottage: “If the cottage is special to you, then give it special planning,” he advises.
TAX PREPARATION
How to minimize the CGT is one of the prime considerations in succession planning, says Bev Moir, senior wealth adviser with Scotia McLeod, a division of Scotia Capital Inc.
If the cottage is in the name of both spouses, the surviving spouse assumes full ownership and the CGT is not applicable.
But if the property is willed to children, it is deemed to have been disposed of at fair market value and the tax kicks in.
Here’s how to calculate how much your heirs would owe the government:
First, determine the current market value.
Next, deduct the adjusted cost, which is the original purchase price plus any money spent on capital improvements, such as a new dock, roof, or an addition.
The tax payable is half of the difference.
Given the tax implications, why not simply sell the cottage to your children at less than market value, or leave it to them in your will?
The first scenario is not practical because the sale must be reported at fair market value for tax purposes.
The second option defers the capital gain tax until your death, but by then the property may have increased in value and your heirs would face a greater tax bill.
To ensure there is sufficient money to pay the CGT, Ms. Moir suggests cottage owners take out a life insurance policy that, upon their death, would provide the cash to cover the CGT. If the parents cannot manage the premiums, they should ask the children who stand to inherit to pay them or share the cost.
Transferring the cottage to the heirs as a gift also triggers the CGT because it is deemed to have been disposed of at fair market value.
The tax impact can be minimized by transferring ownership in stages, either by selling or gifting, while the parents are alive, Mr. Lillico says.
The tax would apply only to the percentage gifted or sold. The parents, he says, should take back a “life interest” in the cottage to ensure their continued use.
This also allows the parents to have control over the cottage, meaning the children can neither sell nor mortgage it without their consent.
Another strategy to reduce tax or even eliminate it is to declare the cottage as the principal residence if its value is more than the city home, Ms. Moir says. There is no CGT on the principal residence.
FAMILY PREPARATION
Ms. Moir advises cottage owners to sit down with their families to discuss who wants to inherit the cottage.
Parents may believe that all their children do, but that is not always the case, she says.
A child who lives far away might never use it and would prefer to inherit cash. Other children might already own their own vacation homes.
Although families might be reluctant to discuss the disposition of a well-loved cottage, “don’t leave it too late,” says Ms. Moir.
Mr. Lillico recommends that cottage owners and their heirs enter into a “cottage co-ownership agreement” to address the myriad family issues that can arise from cottage succession.
The agreement would cover such areas as responsibility for maintenance costs and major expenditures, who is to open and close the cottage, who uses it and when, buyout provisions, what happens to a co-owner’s share in the event of a divorce and how to resolve any disputes. The agreement is legally binding if registered against the property.
“A cottage co-ownership agreement is worth its weight in gold,” Mr. Lillico says. Such a document is “the best insurance policy against loss of family harmony and the family cottage.”
Parents can also avoid family strife after their death by setting aside money in their will for a “testamentary trust.”
The money is invested and administered by the executor to be used exclusively for cottage purposes. It enables cottage expenses to be paid from the trust rather than from the children’s own pockets.
Such a trust, Mr. Lillico says, compensates for any difference in the children’s financial situations, thus avoiding hard feelings if one sibling cannot afford his or her share of the cottage expenses.
The issues and options relating to cottage succession planning are so diverse that parents should consult a specialist or, at the very least, attend a seminar to learn how to avoid the pitfalls, say the experts.
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