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New capital gains rules and cottage estate planning

Don’t sell the property to your child for $1, is one piece of advice from experts who also discuss tax planning and effects of recent rule changes on luxury vacation property market

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With the recent increase in the capital gains inclusion rate by the federal government, Canadians with vacation properties and their advisors had to think quickly about whether to sell before the June 25 deadline, or if not, how to minimize the tax consequences.

One savvy tax move when it comes to vacation properties and cottages might be to designate one as your primary residence – even if you only live there for a few weeks a year – to avoid a hefty capital gains tax bill when it comes time to sell or pass it down to the next generation, says Christine Van Cauwenberghe, IG Wealth Management’s head of financial planning.

“The problem is, of course, that you can only designate one property as your principal residence,” she says.

Vacation properties can often significantly increase in value from generation to generation.

“For families with multiple personal properties, it can come as a surprise when the gain on the sale of their vacation property isn’t exempt if they haven’t designated it as their principal residence,” Van Cauwenberghe says.

“If it turns out that the gain on your vacation property is more significant than the gain on your urban residence, you should be designating your vacation property as your principal residence for tax purposes and then paying the tax on the gain on your other residence,” she continues, adding that it’s necessary to consult a tax professional.

“You want to make sure that you’ve kept proper documentation regarding all of your properties because you never know which one you’re going to choose to pay the tax on.”

For example, if the Muskoka waterfront property has gone from $2 million to $12 million in the time you’ve owned it, it is worthwhile trying to minimize the amount of gain by potentially designating it as the primary residence.

Don’t sell the property to your child for $1

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Van Cauwenberghe cautions against minimizing the gain by artificially manipulating the fair-market value.

For instance, a move like trying to sell the property to your child for $1 or significantly below fair market value (FMV) is a misinformed piece of advice. The Canadian Revenue Agency (CRA) is not likely to go along, and, in fact, you might end up pa ying double the taxes as a result.

“If it’s really worth a million dollars [the fair market value], the CRA is going to deem you to have sold it for a million dollars. You can’t manipulate that,” she explains.

“In fact, you’ll end up with double taxation if you do that because you’ll pay tax first on the gain when you transfer it, and then later again when they say that your cost base is a dollar because that’s what you paid for it. That’s really not good planning,” she says, referring to the fact the capital gains your child will owe on that $12 million dollar Muskoka property will be based on a cost base of $1 and a gain of $11,999,999.

Track those repairs

Van Cauwenberghe says one of the best options to minimize the gain on the property is to maximize the value of your cost base.

“The cost base is all the money that you’ve invested in the property. It doesn’t include annual maintenance and it doesn’t include sweat equity, but anytime you have a major capital expenditure, you should be keeping your receipts,” says Van Cauwenberghe.

“Every time you make a capital improvement to your property, every time you build a new dock or you renovate the kitchen or you do something major, keep your receipts. For some people, the only documentation they have for their property is the value when they first bought it. Sometimes people don’t even have that because they inherited it.

“The cost base of your property is more than just the value when you first acquired it 30, 40 years ago.”

She adds, “You should be keeping your receipts for all of your properties because you never know which property you’re going to designate as a principal residence.”

Capital gains tax reserve and life insurance

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There is also the option to use the capital gains tax reserve and spread out the capital gains over five years claiming 20 per cent of the gain each year, says Van Cauwenberghe.

Then there is the option of using permanent life insurance, “often the most tax-effective way to plan for the gain is through the use of permanent life insurance,” she says.

Many families do not want to transfer their property during their lifetime.

“They know that there will be a significant gain at the time of death, and there’s only so much planning they can do in terms of keeping receipts,” explains Van Cauwenberghe.

“Some of these families have multiple properties, so the principal residence exemption only gets them so far,” she continues.

“They know that there’s going to be a capital gain and they know it’s going to be significant, so they purchase permanent life insurance, which is paid out completely tax-free at the time of death. They use that as the way to ensure that they are able to keep the property in the family.”

Today’s luxury cottage market

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What is happening as a result of the capital gains changes is that those in the luxury market are simply holding on to their assets, explains Christopher Alexander, president of RE/MAX Canada.

“We saw in the early weeks of the announcement that there were a lot of multi-family units owned by wealthy family offices, conglomerates, etc. And as the June 25th deadline approached, they just pulled them off the market.”

The foreign buyer ban has also affected the luxury segment.

“Now, what we’re seeing is a bit of a challenge because of the foreign buyers’ ban in the super premium market. I was in Canmore yesterday coincidentally, and their average days on market for over $8 million has gone up by almost 30 days because they’re missing that segment.”

“Now, what we’re seeing is a bit of a challenge because of the foreign buyers’ ban in the super premium market. I was in Canmore [recently] coincidentally, and their average days on market for over $8 million has gone up by almost 30 days because they’re missing that segment.”

The emotional side of the family vacation home

The family vacation property is often tough when it comes to estate planning because there are so many memories, emotions and siblings tied to one place, says Barbara Kimmitt, a partner at Bennett Jones law firm.

“Most families hope to leave the cabin to all of the children,” she adds.

“This is fraught with problems, such as considerations about terms of use, repairs to the property, and mechanisms that will apply if one of the children wishes to exit their ownership position. Families also need to think about family law considerations if any of their children divorce or die.”

Several of the clients Kimmitt has worked with have decided upon a testamentary trust that will hold the vacation property for a short period – about three to seven years – after the death of the parent. The beneficiaries of the trust are the children and the trustees can permit the children and their family members to use the vacation property.

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“Through a separate letter of wishes, the parent can suggest some parameters for terms of use,” she explains.

“The trust should also have a fund to pay operating costs for the duration of the trust. On the windup of the trust, the trustee can distribute the cabin to the children equally as tenants-in-common, or sell it on the market and divide the proceeds.”

She adds, “It is not a perfect solution … but the idea is to give the children some runway to see what it is like to co-own and operate recreational property with their siblings.”

For families that want to equalize distributions in the entire estate among their children, perhaps leaving the cabin to one child and a cash equivalent to another, they would need to consider how to handle the capital gains issue, Kimmitt says.

They “might want to make the gift subject to that child being responsible for the capital gains tax. In that case, they should specify what inclusion rate should apply if the overall gains for the estate are expected to be more than $250,000.”

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