Retirement by Design Financial Planning LTD

Family Cottages: Holidays or Headaches?
By Arthur Drache

Almost anyone who advises on estate planning will say that family cottages generate some of the most acute planning problems. There are two distinct issues in play. The first is the question of taxes that might be payable when the owner dies and wants to leave the cottage to the next generation. The second revolves around making arrangements for the next generation (if there are two or more children) to share the use of the cottage.

Ironically, the family cottage usually generates more problems than the family home. Few children anticipate moving into their parents’ home once the parents die. But there is an emotional aspect to cottage ownership that is seldom present with an urban house, and more than one family feud has started when well-meaning parents leave the cottage to two or more siblings.

But let’s look at the tax issue first. Until the end of 1981, each family could, with basic planning, own two "principal residences." This was achieved by having both spouses jointly own both the family home and family cottage, or having one spouse own the home and one own the cottage. The significance of the principal residence rule is that there is no capital gain on the disposition of the residence, either on sale or at death.

However, in 1981 the rules changed. Now a married couple can have just one principal residence between them. To complicate life a bit where there were two such residences, the cost base for tax purposes was deemed to be fair market value as of December 31, 1981.

It should be borne in mind that the question of whether a particular dwelling is a principal residence is determined when it is disposed of, not in advance. So the issue of how to treat a sale or other disposition arises only when the disposition takes place. In practical terms, however, you may find that the decision has already been taken without giving the issue much thought.

Consider Max and Jane Green, a married couple. In 1972, when the capital gains regime was introduced, they owned a house with a fair market value of $100,000 and a cottage worth $40,000. They decided, following advice, to register the house in the name of Jane and the cottage in the name of Max. At the end of 1981, when the rules changed, the house was worth $150,000 and the cottage was worth $75,000.

In 1990, they decided to sell the house for $250,000 and move into a condo. The cottage, which they were not selling, was now worth $125,000. Though they didn’t think about it when they sold the house, they had a choice. They could take the position that it was their principal residence and the full gain would be tax-free. Alternatively, they could have decided to treat the cottage as the principal residence by deciding to pay tax on the house sale.

If they opted to pay tax on the house sale, they would have had a capital gain of $100,000, the $150,000 value in 1981 becoming the cost base. Making this decision would ensure that any gain on the cottage would be free of tax when it was disposed of, probably when they died and left it to their kids. Now at that stage, the potential gain on the cottage was only $50,000, using the 1981 value. So, the rational approach was to elect tax-free gains on the house, which they did.

The cottage is now a ticking tax time bomb. Its cost base is $75,000 but there is a potential tax liability that grows as the value increases -- if it does.

The upshot is that there will be a major tax bite on the cottage when it is left to the kids or when it is sold. If it is sold, the taxes will be paid out of the proceeds. But if it is left to the next generation, there will be tax liability at the transfer of ownership without the cash to pay it.

Experience shows that no matter how one twists and turns on this issue, the easiest way to deal with this potential problem is life insurance. A policy should be taken out on the joint lives of Max and Jane, payable when the second dies. Their wills leave the cottage to the surviving spouse, which means that the insurance money comes in when the second dies, cottage ownership is transferred, and tax becomes due. (Second-to-die insurance is usually cheaper than a single policy and can often be used when one of the spouses is uninsurable.)

Taking this approach ensures that the cottage can pass to the next generation without any major cash-flow problems for the estate.

And how do you arrange for the shared use of the cottage between two or more children, each of whom may also have kids and all of whom will want the use of the cottage at overlapping times? This produces a conundrum that is extremely difficult to solve. The best of a range of poor options is to force the kids to enter into a mutual agreement that sets out a formula for sharing use of the cottage before it is bequeathed to them jointly.

This agreement should also have a buyout provision under which the children can force a buyout of their sibling’s shares. The usual approach is a "shotgun" agreement under which one child makes an offer to buy the other’s interest at a stated price and the person getting the offer can either buy or sell on those terms.

Be aware that neither agreements nor forced buyouts will necessarily lead to family harmony.

If possible, try to find out in advance if any of the children are willing to forego an interest in the cottage and, in exchange, leave a compensating cash bequest to them. This bequest can also be funded with insurance money if necessary.

The most important thing to keep in mind is that a cottage that is escalating (or has jumped) substantially in value may turn out to be a problem in terms of your estate planning. Solving this issue will be one of the trickiest parts of estate planning. But, a failure to deal with this issue may be the wedge that creates both family animosities and tax problems. It is therefore important that time be taken to assess all aspects of the issue -- and that this should be done in consultation with the next generation.

This article was prepared by Terry Fay who is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst*. The views (including any recommendations) expressed in this article are those of the author alone, and they have not been approved by, and are not necessary those of Dundee Securities.

The particulars contained herein were obtained from sources which we believe reliable but are not guaranteed by us and may be incomplete. The opinions expressed have not been approved by and are not those of DundeeWealth Inc., its subsidiaries, or its affiliates, including, but not limited to Dundee Securities Corporation, Dundee Private Investors Inc. / Ltd., Dundee Insurance Agency Ltd., Dundee Bank of Canada and Dundee Mortgage Services. This website is not deemed to be used as a solicitation in a jurisdiction where this Dundee representative is not registered.

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