After you’ve built special family memories in a vacation home, it’s easy to take for granted that it will continue being enjoyed by your family even after you’re gone. Without advance planning, however, those cottage dreams may not survive your passing. Here are a few considerations to help when planning what will happen to your family vacation home after you’re gone.
Talking with your family
Before you begin planning, it’s worth having an honest conversation with your family to discover if they share your dreams to keep the property in the family. Perhaps they don’t anticipate enjoying it as much if you’re no longer around, or they may be concerned with other priorities such as paying down debt, growing a business or funding children’s education. They may even worry about family squabbles over how time is allocated or costs are shared, once you’re no longer at the centre of such decisions.
How will taxes be paid?
It is important to consider when or if taxes will be due, and, if so, how those would be paid. Real estate is subject to capital gains taxes upon death unless a principal residence exemption (PRE)1 or a tax-deferred rollover (e.g., to your spouse), is available and claimed. The current capital gain inclusion rate is 50% of the gain, which is the taxable portion. Note that transferring a property to joint names with someone other than your spouse is usually considered a disposition at fair market value (FMV), which can accelerate the timing of capital gains before your death.
Common planning strategies for a family vacation home
Before taking any action, it’s important to consider planning strategies such as the ones below with your estate and tax planning professionals. For example:
- Leaving the property to family as a bequest in your will – A primary benefit of this option is the deferral of taxation until your passing, the possibility of claiming the PRE for an extended period and maintaining control of the property up until that time. Furthermore, you could bequeath the property to a testamentary trust through your will, prolonging your control over the property posthumously while allowing for its use by your selected beneficiaries.
The primary drawbacks of such a plan include the application of probate on the FMV of the property at the time of death (up to 1.4% in BC) and the tax liability assessed upon the estate for any capital gains taxes arising on the deemed disposition. If there is insufficient liquidity within the estate, the property itself may need to be disposed of to pay the resulting tax.
- Transferring the property before passing – This strategy may result in a number of benefits, including a potential reduction in capital gains tax as the future growth is taxable in another individual’s hands, or the potential for the transferee to claim their own PRE. Transferring early may also allow for a disposition over time which may ultimately reduce tax – capital gains on a disposition of property can be recognized over a period of up to five years if the proceeds are received equally over the same period of time. This can prevent the capital gain from being taxed at a higher marginal rate. Lastly, probate fees would be avoided.
Drawbacks to transferring early include the loss of control over the property, the potential for the property to compose a portion of marital assets in the event of a transferee’s relationship breakdown and the application of property transfer tax assessed on the FMV, depending on the jurisdiction in which the property is located.2
Careful consideration must also be given to the form of transfer – gifting versus selling. Where a property is gifted to a child or other non-arm’s-length individual, the transferor is deemed to have received FMV proceeds and must pay capital gains tax thereon. The transferee is then deemed to have an adjusted cost basis in the property at that FMV, ensuring that any future capital gains tax will only be based on future growth in value. However, where the property is sold for anything other than FMV, the transferor is still deemed to have received FMV proceeds, while the transferee is deemed to have an adjusted cost basis equal to whatever amount they actually paid. This results in double taxation for the family as a whole.
- Using a co-ownership agreement to outline expectations – Creating a co-ownership agreement could help alleviate future disputes and promote family harmony. For example, the agreement could clarify who pays future upkeep and renovation costs, how rental income will be allocated, who can occupy the home for which periods, how future disputes will be managed and/or what restrictions might be placed to prevent selling or encumbering the property, such as stipulating that certain persons must consent to a sale or mortgage.
- Using insurance as part of your strategy – An insurance specialist can help determine whether life insurance is appropriate for your planning goals. For example, they can help determine if the liquidity in your estate will be sufficient to cover the estimated capital gains taxes and other obligations arising after your death and, if not, recommend a life insurance solution to enhance that liquidity. Or, if you plan to transfer property before death, they can suggest solutions to build additional wealth that could be used to cover later costs, such as maintenance or renovations, so that the property can remain in the family.
Insurance may also be appropriate to help provide an ‘equalization payment’ if children or grandchildren will disproportionately share in the vacation property. In each of these scenarios, life insurance death benefits can be paid tax-free.
If you would like more information on the insurance options available through Odlum Brown Financial Services Limited, contact us through your Odlum Brown Investment Advisor or Portfolio Manager.
1 The PRE is an exemption on the capital gains tax arising on the disposition, deemed or otherwise, of real estate that has been ‘ordinarily inhabited’ in any given year of ownership by the owner or the owner’s children or grandchildren. While ‘ordinarily inhabited’ is not defined by the Income Tax Act, the courts have allowed relatively short periods of time to qualify, so long as there is some regularity to it. Only one PRE can be claimed for any particular year.
2 Property transfer taxes apply in varying rates in a number of provincial and territorial jurisdictions across Canada. In BC, the general property transfer tax rate is 1% of the FMV up to and including $200,000; 2% of the FMV greater than $200,000 and up to and including $2,000,000; and 3% of the FMV greater than $2,000,000.