Good record-keeping key to tax-efficient cottage estate plan
By AdvocateDaily.com Staff
In the second instalment of a four-part series on transferring ownership of the family cottage, Winnipeg wills and estates lawyer Cynthia Hiebert-Simkin discusses the cost of a cottage estate plan.
Meticulous record-keeping is a must for testators hoping to maximize the tax-efficiency of the family cottage estate plan, Winnipeg wills and estates lawyer Cynthia Hiebert-Simkin tells AdvocateDaily.com.
Hiebert-Simkin, a partner with Tradition Law LLP, Estates and Trusts, says capital gains tax is likely to be a factor in any transfer of a cottage, especially when the property has been in the family accumulating value for a long time.
However, she says the tax is only calculated on the difference between the fair market value at the time of the cottage’s disposition and its cost-adjusted base, which deducts the amount of any capital improvements from the original purchase price.
But since capital improvements may have taken place over many years, Hiebert-Simkin says it can be a struggle for some clients to provide the requisite supporting evidence, explaining that the Canada Revenue Agency (CRA) will only deduct proven capital expenses that provide a lasting benefit to the property.
For instance, she says the CRA may not allow a deduction for the cost of repairing wooden stairs in a cottage but are more likely to approve a cost-adjustment if they are replaced altogether with new concrete steps.
“If you can’t do it yourself, my recommendation is to hire an accountant to keep track of all the expenses on an ongoing basis, so that if you’re ever challenged by the CRA, that information is readily available,” Hiebert-Simkin says. “If it’s not easily available, it can prove to be a major headache either for the estate trustee or a person acting under a power of attorney to sell the property during your lifetime.
“If you’ve made improvements that you have no receipts for, the CRA could say ‘too bad,’” she adds.
Hiebert-Simkin says the legislative history of the capital gains tax adds another layer of complexity to estate plans involving family cottages.
Regardless of when the property was bought, valuations are only relevant from 1972, the year the tax was first introduced.
“Any appreciation in value up to 1972 is not taxable, but you would need evidence of what the value was in 1971 to get the exemption,” Hiebert-Simkin says.
Owners who bought their property before 1994 may also be able to take advantage of a personal lifetime capital gains tax exemption of up to $100,000 that was introduced in 1984. Although the exemption was repealed a decade later, taxpayers who declared their unused portion on a 1994 tax return were allowed to carry it forward.
She says cottage owners may also be able to take advantage of the principal residence exemption (PRE) to capital gains tax when disposing of a family cottage.
However, since PRE rules have been tightened up over the years, Hiebert-Simkin says the decision on whether or not to invoke it will depend on the adjusted cost base of both the cottage and the main family home at the time of the sale of the first property.
“People assume they will be claiming the PRE on the sale of their house, but if you determine that the cost-adjusted capital gain is larger on the cottage, it might make sense to make it your principal residence,” she says. “There’s a great deal of paperwork people have to do, and unfortunately they’re often unaware of the need to keep track of their adjusted cost base expenses.”
Capital gains tax is only triggered when an asset is disposed of, but Hiebert-Simkin says determining when disposition has occurred is not as simple as it sounds.
“It includes both the sale of the cottage and its transfer,” she says. "There will also be a disposition after the owner’s death which has to be declared on the final T-1 personal tax return."
In many cases, parents may either gift the property to a child or sell it for a reduced or token amount during their lifetime, but Hiebert-Simkin says capital gains tax still must be paid as if it was sold at fair market value.
“The parents will have to pay the tax, and tie up money that they may have wanted to have available for a big trip or other purposes in their old age,” she says.
Adding a child to the title — often a questionable transaction in any event Hiebert-Simkin says — is also no escape from capital gains since the tax must be paid on the portion of the property transferred to the new owner.
When a cottage passes through an estate to a specific beneficiary, Hiebert-Simkin says testators need to consider how the capital gains tax will affect the fairness of their bequests, since the tax is considered a liability of the estate, and paid from the estate's proceeds before the distribution of the residue.
For example, in a case where a parent has two children, they may decide to leave one child a cottage worth $500,000, while the other child inherits the rest of their assets, valued around $500,000.
However, if the capital gains tax on the cottage amounts to $100,000, this will reduce the second child’s share to $400,000, Hiebert-Simkin explains.
“Only one person’s share will be affected by the debts and expenses incurred by the estate,” she says.
Hiebert-Simkin says the solution will depend on the wishes of the testator, but one option is to purchase insurance to cover the expected cost of the tax.
Alternatively, the parent could make a specific gift to the child who is not receiving the cottage of roughly equal value, directing the residue to be shared between them.
“You can also decide that it doesn’t have to be perfectly fair, and some families will be fine with that,” Hiebert-Simkin adds. “But there are many families where that will not fly.”
Click here to read part one, where Hiebert-Simkin discusses why communication is so vital.
Stay tuned for part three, where she will explore how changes in life circumstances should affect a cottage estate plan.