The family cottage up north. The cabin on the lake. The beach front property. A vacation property can take various forms for many people but one thing is certain. The need to ensure the proper family cottage succession strategy is in place. Its one of the items we review in our Financial Life Planning process. The concept is to keep family memories intact by ensuring the cottage transitions to the next generation without family fights that can tarnish the enjoyment of the property.
Drawing from a client example, when the parents passed away unexpectedly, there was no question that the cottage would land in their son’s hands. As the youngest in the family, he had enjoyed the cottage more than his siblings. His parents had purchased it as his older brothers were leaving home. Other families are not so lucky. Perhaps no one in the next generation can afford to keep up a cottage. Some cottage areas have seen valuations shoot through the roof. Sometimes the children live too far away. A cottage is no picnic. All vacation properties require work and regular maintenance. This can be too much of a burden.
The concept is how do we put strategies in place to ensure this. It starts by planning ahead when you still have viable options. Family dynamics are always part of the equation as well. After investing in a vacation property and enjoying so many memories there, you want to look at your options in keeping the family in the family cottage without causing a rift.
The first part of this process is identifying the challenges that families face in creating their own strategy. That’s the beauty of a Financial Life Plan. The strategy you create is unique and adaptive to your family. Here are the primary obstacles that must be overcome with a successful strategy:
Capital Gains Tax (CGT) – This must be paid when the cottage is sold or transferred, whether the previous owner is living or has died. Although the federal government recently reduced the impact of this tax, the amount could still force a family to sell rather than pay a large tax liability.
Keeping the cottage going – How will you use and operate the cottage? This is the time to work out logistics such as bills, exclusive use and changes to the property. You also need to look ahead to the next generation in the event of an unexpected death or divorce.
Managing Expenses – A frank family discussion about managing the maintenance of the cottage is a good start but they need to be updated as people retire, lose their jobs or suffer an illness that prevents them from working. A family break-up can throw finances into chaos, so consider all the options if you go this route.
Steps to a Successful Strategy
Estimate the CGT
You need to know your fair market value (FMV), the adjusted cost base (ACB) and the impact of any capital improvements. The FMV can be determined from the latest property tax assessment, any recent appraisal or comparative values that local cottages have sold for. The ACB is essentially the purchase price of the cottage (depends on if you bought it before or after 1971). The FMV less the ACB and capital improvements determines the capital gain that is subject to tax. Half of the capital gain is subject to income tax. Your Family Life Planner can assist with this calculation as part of your Financial Plan usually in consultation with an accountant.
Transitional Timing
The CGT can be tempered by the transition. If you plan ahead, you can switch cottage ownership in stages. If you transfer 20% each year for 5 years, the CGT in each year will be much less. Part of this strategy is in keeping in step with the effect on your OAS. If you go over a certain limit, CRA will claw back part of your income. If you time the transfers to occur over more than one year, you can stay within that threshold.
If you cannot afford the multi-year transfer, you can ask your kids, the future owners to pitch in. For example, if you have four children, a $20K tax gain can be split to $1,200 per child per year thus avoiding a large future payout.
If you leave the cottage in your will, the CGT will be deferred until after your death. Either way, you can designate your cottage as your principal residence and be exempted from this tax altogether. You need to look at the implications of this decision before making the switch to see what works for you.
Paying the CGT
Everyone’s financial situation is different, so a Financial Life Planner will assist you in finding a creative solution that works for you. Here are some of the options available to you:
- Sell your cottage
- Sever and sell a lot off the cottage property
- Draw on your savings and investments
- Take a mortgage on the cottage
- Increase your life insurance coverage
Our preferable strategy is having foresight and increasing your life insurance coverage. If the premiums are large, you can ask your children to help pay the higher premiums. Your children could actually also put a mortgage on the cottage and pay that off giving them the cash flow to cover the taxes.
Strategy Planning
With a plan in place to pay the CGT, the next step is to decide upon which transition strategy works best for your family situation.
Leave the cottage to the children in your will.
Gift the cottage to the children now. This recognizes that the CGT costs are the same as selling it to the children. Because it is a gift, you will not have the sale proceeds to pay the CGT. You must report the value of the transfer on your income tax return as a taxable disposition using the FMV.
Sell the cottage to the children at FMV or less. However, you still must report the sale at FMV for tax purposes.
Transfer a percentage of the cottage to the children in stages over several years, as a gift or a sale. Either option will trigger CGT if there was a gain.
Retain a life interest in the cottage for the original owners, whether gifted or sold, by registering that description to the title. By doing so, the children agree to give their parents the legal right to use the cottage and the younger generation cannot sell or mortgage it without their consent.
Once a strategy is created, it is very important to document that in a legal agreement between the family members. Your Financial Life Planner will consult with an accountant and a lawyer in the structuring and documentation of the strategy in a legal document. The most important aspects of this legal documentation with include:
Create a co-ownership agreement
As in most families, there are always disagreements. The purpose of the co-ownership agreement lays out the rules of who does what on paper. In most families, the parents have the final decisions but the family power structure becomes far more complicated when the parents are no longer around. Its best to prepare this written agreement while the parents are still the primary decisive voice. Some of the items that should be covered off are:
- Who opens/closes the property each season,
- Who pays the bills and how they are shared,
- Who gets to use the cottage when and who they can bring along,
- Who decides on additions or improvements,
- Who can a child sell his or her share and, if so, to whom, and
- What happens if one co-owner dies.
This is essentially a business partnership agreement and should be treated as such. This document will clearly define which items will be decided by a vote and which ones require unanimous approval, and how disputes will be resolved. The key is that this document details the family agreement in writing. Its best to have a lawyer prepare it. That’s what we did in my family.
Create a cottage trust
One of the difficulties in a cottage co-ownership agreement is that the co-owners have different incomes and financial commitments. It can be a challenge for everyone to contribute their share when it is required. Rather than fight over who owes what, create a cottage trust.
In a cottage trust, parents can set money aside as part of their wills to be used for cottage expenses only. Invest the money and have an executor use the investment income to lower the costs to maintain the shared property and keep the capital set aside for future maintenance and major expenditures. While cutting into the capital will lower the annual amount available for cottage operations, it takes the stress out of finding the money for it.
No one set of rules will suit each family, so we start talking now as you admire the night sky and everyone is in an amicable mood. It is our philosophy to be forward thinking and pro-active in the creation of your Financial Life Plans. It will pay off when life hands you a new set of playing cards. That’s when emotions are running high and you need that quiet day on the lake more than ever. We encourage our clients to appreciate this as part of Keeping Life Current.
