Hey there, time traveller!
This article was published 7/10/2011 (2059 days ago), so information in it may no longer be current.
As the old saying goes, the only guarantees in life are death and taxes. It's an ugly truism, often painfully driven home when it comes to passing the family cottage from one generation to the next.
After all, the family patriarch who owns the piece of lakeside paradise can't live forever. When he does pass the cottage on, the Canada Revenue Agency (CRA) will want its tax share of any capital gains made during the years of ownership.
So the question arises: What strategy works best for transferring an asset worth hundreds of thousands of dollars in a tax-efficient manner that's also acceptable to all family members involved?
The answer depends on each individual family, but one thing is certain, says Larry Fayle, director at Scotia Private Client Group in Winnipeg.
"Whether the cottage has been in the family for generations or is a recent purchase, it's a prized jewel for most families, and if they want to continue to have that passed on for generations, a well-thought-out plan needs to be in place."
Of course, determining what the plan will be is far from easy, experts say. Countless articles have been written and seminars have been held, all aimed at providing the clearest answer, says John Poyser, a lawyer and a Free Press business columnist who writes about estate-planning issues.
"The frustrating thing is, the answer for each family is it depends upon the delicate interplay between a variety of factual circumstances and a variety of provisions under the Income Tax Act," says Poyser, with Wealth and Estate Law Group.
The best way to begin is to break the process down into "building blocks," says Poyser, one of three experts speaking at a cottage-succession seminar hosted by The Knowledge Bureau next weekend at the Winnipeg Free Press News Café.
Capital-gains tax considerations may be the most talked-about building block, followed by probate fees.
But two other blocks, though more touchy-feely, are equally important.
One deals with immediate family relationships. Generally, splitting ownership of a cabin among children, while mathematically equal, does not equate to a fair deal.
"Everybody has a different stake," Fayle says. "Fair does not always equate with an equal share of the cabin."
Figuring out what is fair often isn't easy. The family needs to meet and discuss the matter. The goal is to avoid long-term family disharmony.
"In my experience, the two most common ways to destroy a family around a cottage are No. 1, to do your cottage plan in secrecy without the children," Poyser says.
"The second way is to dump it into joint ownership, or common ownership, without any mechanism in place to resolve disputes or other issues, like sharing time."
Feuding among siblings over who spends May long weekend at the cabin can be troubling enough. Throw in strife with the in-laws and a poorly laid-out estate plan, and you've got a recipe for a legal and tax nightmare. Avoiding that divorce-related hazard is the fourth building block.
Poyser says inheritances and gifts, such as a cabin, are not considered communal property in divorce proceedings, so at first glance, the in-laws can't get a share when marriages go awry.
"A family member could, in theory, marry and divorce as often as Elizabeth Taylor and never see the cottage in the financial equation at any of the breakups."
In reality, however, it's often more complicated.
"Because cottages are often money pits, the child and his or her spouse have devoted tens of thousands of dollars out of the marital pot into the non-sharable asset," he says. "That frequently results in the loss of protection around the cottage."
The situation is avoidable, but it may involve costly hours in a lawyer's office -- and only after the family first discussed the future of the cabin.
Once these "soft" building blocks have been resolved, the tax and probate fees issues can be addressed to provide the most financially efficient execution of the plan.
Poyser says probate fees often arouse more anxiety than they should. These fees cover the court costs for validating the will. In Manitoba, fees are $7 for every $1,000 of assets in the estate. On a $200,000 cottage, that's $1,400 in fees -- chump change compared to the capital gains tax when the cottage changes hands.
Undoubtedly, the capital gains building block is the most complicated financial issue because owners of two or more residences often can elect to have the cottage designated as a principal residence, which exempts it from capital gains taxes, says Evelyn Jacks, author of Essential Tax Facts and president of The Knowledge Bureau.
But it's not as simple as selecting the property -- cabin or home -- that has gained the most value over the years for the exemption.
Jacks says owners need to consider a number of factors in calculating the taxable capital gain, such as valuation dates dealing with when certain taxation rules came into effect and the adjusted cost base, which includes the cost of improvements made to property over time.
It may also be the owner has moved to two or three homes without paying capital gains taxes on those transactions during the course of cabin ownership, which may eliminate the cottage as the principal residence for those periods. "Alternatively, transfers can happen during lifetime or at death, in which case tax consequences can vary," she says.
Crunching the numbers for each individual case is different, and paying as little tax as possible isn't always the best strategy. Often, those softer building blocks play a bigger role, she says.
"Family harmony is so important in planning, because the cabin is where all the good memories are, and so you can't just let the tax tail wag the dog."
The Knowledge Bureau is holding a cabin succession planning seminar next Saturday from 8 a.m. until noon at the Winnipeg Free Press News Café, 237 McDermot Ave. Admission is $95. The event is geared to helping families save time and money spent with a lawyer, says John Poyser, legal expert at the seminar. "What we're trying to do is give guests the building blocks and then help them go through a decision tree where they can push solutions off the table and narrow it down to a couple of solutions," he says. "Afterward, they might vet it through an accountant and a lawyer to make sure they're barking up the right tree." Additional family members can attend for $75. Call 953-4767 or email email@example.com to register.
Mechanics of a principal-residence exemption
Grasping how the exemption works is difficult without seeing an example to demonstrate how the capital-cost base, valuation days and taxes work together. Here's an example:
1) Hal buys a cottage in 1960 for $1,000. The family already owns a home, which they bought in 1958 for $6,000.
2) At that time, capital gains taxes did not exist. It wasn't until Jan. 1, 1972, that capital gains taxes applied to assets such as property, so any growth on both properties until Dec. 31, 1971, is tax- exempt. This is the first valuation date. Hal still needs to know the properties' values at that time to calculate the exempt growth. At the end of 1971, the cottage was worth $10,000 and the home was worth $30,000. The $9,000 growth on the cottage was exempt and so was the growth on the home. However, the taxation rule change allowed for two principal-residence exemptions per family, so any growth after 1971 remained exempt until the next tax-law change in 1982.
3) On Jan. 1, 1982, taxation rules changed to allow only one principal-residence exemption per household. At this stage, let's say Hal sold his home two years earlier for $50,000 and bought another home for $70,000. He still owns the cottage, which is now worth $25,000. Until this point, all growth on the properties is exempt from capital gains tax. Even though Hal sold his home and paid no capital gains taxes at sale, he still had the principal-residence exemption available, because at the time of the sale he was allowed two principal residences. But from 1982 onward, capital gains taxes may be applicable to one property because the rules changed, allowing for just one exemption. At that time, valuation of the properties was necessary.
4) The next date is Feb. 22, 1994. Under the tax rules of the day, owners could use a $100,000 capital gains exemption on the sale of taxable assets. Any property owned after 1981 and before Feb. 22, 1994, that had not been designated a principal residence was eligible for a $100,000 capital gains exemption. But even owners who didn't sell their property during that time could elect to use the exemption on the Feb. 22 valuation date. Hal elected to use the exemption on his cottage, worth $90,000 in 1994. That raised the cost base of the cottage to $100,000. In addition, his home, worth $100,000 in 1994, was now de facto his principal residence between 1981 and 1994. Any gains in value on the home during that time period are also tax-exempt.
5) Today, Hal is ready to pass the cabin on to his son. The cabin is now worth $250,000 and his home is also worth $250,000. He has to choose the principal-on residence exemption for one of the properties. Because of the 1994 exemption election, taxable growth on the cottage is from 1994 to 2011. Growth is $150,000, but costs to improve the cottage during that period are subtracted from the gain. (This "adjusted cost base" is subtracted from the fair market value on the transfer to his son. Hal has spent $30,000 improving the cabin during that period, so the total gain is $120,000, of which $60,000 is taxable at the marginal rate of 46.4 per cent. Tax payable is $27,840.
6) Hal's home grew in value since the last valuation day in 1982. Half of any gains, after taking improvements into account, could be subject to tax if this property is chosen as the taxable one. "Form T2091 sorts it all out, including the effect of the Feb. 22, 1994, election," says tax planner Evelyn Jacks. While Hal could pass the cottage on as a gift and use the principal-residence exemption to do it tax-free, he also has to consider that if he then sells his home and moves to a condo, he will have to pay capital gains taxes upon sale of the home for the period of time in which it was the second residence, if any. So long story short, Hal has more thinking and planning to do.
-- The Knowledge Bureau