Tax, probate, and underused housing tax for your family cottage

Planning to leave the family cottage to your kids in your will? Here’s how to minimize capital gains tax as part of your estate planning.

Capital gains tax on a cottage

Capital gains tax generally applies to real estate in Canada. The primary exception is the principal residence exemption that can be claimed on eligible real estate ranging from houses to cottages to cabins to mobile homes. 

In order to claim the principal residence exemption, a taxpayer must typically use the property in question, even if it is not the place they primarily live. Assuming the property has not been used for business or rental purposes, the sale proceeds of a principal residence can generally be completely tax-free. 

While it’s possible to claim a cottage or cabin as your principal residence and have the proceeds be tax-free, it would be uncommon. A Canadian taxpayer’s home is usually worth more than a secondary or vacation property. But, of course, it depends on the circumstances. 

Qualified advice on capital gains

In this case, Cal, I worry that either the accountant misspoke, or your father-in-law misinterpreted their advice. Although your in-laws could claim the cabin as their principal residence, doing so would expose some or all years of ownership of their house to capital gains. 

A taxpayer can only claim one principal residence for a given tax year. Say, they owned their house for 35 years and the cabin for 20. They sell the cabin now and claim the principal residence exemption on it, and then sell their house five years later. For the house, 20 years out of 40 years, or half of the capital appreciation, would be tax-free. But the other half would be taxable. These 20 years come from the first 15 years prior to owning the cabin and five more years after selling the cabin. 

Note that the value of the house when the cabin was purchased and its value when the cabin is sold are not relevant. The capital gain would be a pro-ration based on the years of ownership going back to the house’s original purchase price, plus any adjustments like acquisition costs and renovations.

When to claim principal residence exemption in Canada

You claim the principal residence exemption on your tax return for the year in which you sold a property. It’s not something you need to decide ahead of time. In your father-in-law’s case, Cal, if he and your mother-in-law intend to keep both properties indefinitely, we should consider the tax implications upon death.

When someone dies, if they leave capital property, like real estate, to a surviving spouse, the default position is that the property passes to the surviving spouse at its original cost, plus any adjustments. No capital gain is triggered. 

You can elect to have a capital gain, or a partial one, if it makes sense to do so. Say, for example, the deceased had a low income in the year of death, or other tax deductions or credits that their executor wanted to claim against the income and tax payable. 

Capital gains tax would generally only become payable when the second spouse passes or if a property is left to someone other than the surviving spouse.

The claims to make to lower a capital gain  

You mention keeping receipts and given that the values of the two properties are similar, your in-laws may want to have a record of expenses for both to keep their options open. One document to keep might be the lawyer’s statement of account for the purchases, which includes the legal fees, land transfer tax and other closing costs. If your in-laws don’t have these statements, the lawyer(s) may be able to provide copies. 

Also, receipts related to renovations and capital improvements to the properties are relevant. These costs, as well as the eventual selling costs like the realtor’s commission or legal fees, may reduce a capital gain.

What is beneficial ownership?

The fact that your father-in-law added his children’s names jointly on the cabin has several implications. For one, by default, this approach generally results in the presumption of resulting trust, where only the legal ownership of the property has become joint. Beneficial ownership remains with your father-in-law and mother-in-law. Beneficial ownership means the person who technically owns the property. If everyone still acts like it belongs to them, they still pay the ongoing costs, and nothing has really changed since they added their children’s names, no change in beneficial ownership has occurred. 

In that case, the good news is that there’s no capital gains tax payable at the time they added their children’s names to the cabin’s title. Otherwise, if a gift of part of the property took place, your in-laws would have had a deemed disposition, which would have to be sheltered from tax by the principal residence exemption or it would have been taxable as a capital gain. Even though no money changes hands, a transfer to a non-arm’s-length individual like a child is considered to take place at the property’s fair market value. You cannot just transfer it for a dollar to avoid capital gains tax.

Does adding beneficiaries to a cottage avoid probate?

Interestingly, the common approach of adding children’s names jointly on assets may not help avoid probate. If beneficial ownership has not changed, an asset may need to be disclosed on a probate application and be subject to estate administration tax. When adding children’s names to real estate or a bank or investment account, the best approach for tax, probate and legal reasons is to write a declaration of the intention for doing so.

Anyone considering adding a family member jointly on title to real estate or other assets should consider the income tax and probate implications. Seemingly simple strategies may have unintended consequences and complexities, and require advice from different professionals. 

In your father-in-law’s case, Cal, he may want to dig a little deeper with his accountant and consider estate law advice here as well. 

How cottage renos can reduce your capital gains

Phylis and her son own a cottage together. She wants to understand the future tax and estate planning implications

What to claim to lower capital gains

You’ve raised a number of different points, Phylis. You mention “willing” your share of the cottage to your son. I suspect that may mean you both own your respective share of the cottage as tenants in common, meaning your 50% interests are distinct and can be dealt with separately—including in your wills.

If so, you certainly can designate your share of the cottage to go to your son in your will. You could do so with a reference to this in your will, either by preparing a new will, or preparing a codicil to add a new clause to your existing will.

Joint ownership of a cottage and rights of survivorship

I find that people are often confused with joint ownership. If your ownership was actually established as “joint tenants with rights of survivorship,” your share would pass to your son as the survivor directly upon your death (and vice versa). It would not pass through your will at all. Make sure you know how the ownership was established initially, Phylis, so you can understand the estate implications.

You could consider changing ownership from “tenants in common” to “joint tenants” if you both wanted the property to go to each other on death, although your son may have other beneficiaries, like a spouse or his children, who he wants his share to go to instead. Joint tenancy may help you reduce the costs to settle your estate and expedite things on your death as well.

When a taxpayer has more than one property, like owning both a house and a cottage, only one can be designated as her or his principal residence in a given year. When you sell a property—or when you’re deemed to have sold it, on your death—that’s the point at which you make a designation whether some or all years of ownership are tax-free as a principal residence.

People’s homes tend to be more valuable than their cottages, in which case the cottage capital gain is often treated as a taxable capital gain, with a home being their tax-free principal residence.

What is the lifetime capital gains exemption? Does it still exist?

There are other considerations if you owned the cottage prior to February 1994. A $100,000 lifetime capital gains exemption existed until that time, and you may have claimed a deemed capital gain to bump up your cottage adjusted cost base. And if you owned prior to 1972, there was no capital gains tax until January 1, 1972m so some of your cottage capital gain may be exempt from tax.

Assuming you and your son, Phylis, will have capital gains tax to pay on the cottage, the construction, capital improvements, and renovations you did may reduce the future tax payable by increasing the cost base and reducing the capital gain. It’s important to keep proper records to support a claim. It’s also important to note: If you did any work yourself on a cottage, you can’t put a value on your labour—you can only add labour paid to a third party to the cost base for capital gains tax purposes.

There’s another important point with respect to the excavator, skidster and barge. You can generally only capitalize the cost of materials for a do-it-yourself cottage build. Equipment you purchased has a value after the construction is done and can be sold or used for other purposes. The cost of equipment you rent or lease during construction may be an eligible capital cost and added to your adjusted cost base.

There are a few other considerations, Phylis. Assuming the property was beneficially half yours, and that you and your son contributed equally to the purchase and construction, you would have a capital gain on your death. That is, as long as the cottage wasn’t considered your principal residence. If you were just on the property so your son could qualify for a mortgage and it was beneficially his, you may not have to claim a capital gain. The value and the potential tax implications may be his alone in this case.

Another consideration is whether there would be enough liquidity in your estate to pay the capital gains tax. If you have other children or other beneficiaries, just make sure you take into account how much tax will be payable on the cottage and what that means for the remaining net estate value to be divvied up amongst others, if applicable.

If the capital gain is significant, the new higher capital gains inclusion rate of two thirds may apply to a capital gain in excess of $250,000. Most individual taxpayers will not run into this situation except for the sale of a valuable asset like real estate due to the $250,000 exemption.

Reducing capital gains on the sale of a cottage

Fred’s mother wants to claim the cottage her principal residence before selling it to the kids.

Inheriting a cottage and capital gains

Every Canadian can have one principal residence each year for tax purposes. It doesn’t have to be your home. It can be your cottage. It just needs to be a property you ordinarily inhabit, with no minimum requirement. If you only have one property, selling it generally has no tax implications. Your mother owns a cottage, like many Canadians, so the result is that there is likely capital gains tax to pay in the future.

In your case, Fred, you’ll need to look into the past to get your answer. If your mother had a home that she owned previously, it is likely that when she sold it, she didn’t report a capital gain or pay income tax on that sale. If that’s the case, if we assume she sold it in, say, 2010, the cottage will qualify as her principal residence for subsequent years, but not prior.

Say, she bought the cottage in 1990, and she sold it in 2014. She will have owned it for 25 years upon the sale. But for only five of those years (2010-2014 inclusive) will it be her principal residence and qualify for a tax exemption.

If she has a $100,000 gain based on the original purchase price, 20/25ths or 80% would be taxable to her.

If she owned the property prior to 1995, you should see if she made an election in 1994 to increase the cost base of the property, by way of the $100,000 lifetime capital gains exemption that used apply until that year.

If she owned the property prior to 1982, the property may be exempt from tax prior to that point, because she and your father were both allowed to designate one property each as their principal residences.

And if she owned the property prior to 1972, the capital gain prior is tax-exempt as capital gains taxes weren’t payable by Canadians until that time.

How renovations can lower capital gain

Renovations or improvements made over the years may qualify as capital costs that can be added to her original purchase price and decrease the ultimate capital gain.

If she’s going to sell the cottage to her children, the property needs to be sold at fair market value. In other words, you can’t choose an arbitrarily low value to reduce the capital gains tax. Money doesn’t necessarily need to change hands. A cottage can be gifted. Whether it is gifted or sold for a low value, the transaction takes place at the fair market value for tax purposes.

You and your siblings might consider paying for the property over a period of five years if the capital gain is quite large, depending on her tax situation and need for the sale proceeds. This way, as little as 1/5th of the capital gain would be taxable to her in each year over five years, while locking in the price today, by claiming a capital gains reserve.

No matter what you do, your mother is going to pay tax on the cottage eventually. Whether she sells it to you kids or is deemed to sell it when she dies, a taxable cottage capital gain is inevitable.

Sometimes, when it comes to cottages, people get carried away with avoiding or reducing capital gains tax or probate fees but end up incurring significant and unforeseen costs. So, I think tax should be just one of your concerns here, Fred.

Selling a cottage to family members

If your mom genuinely wants to sell the cottage to you and your siblings, and you all want to buy it, that’s one thing. But if you’re doing so just to get it out of her name and stop the capital gains tax from growing, you should take into account other considerations.

In particular, your mother would give up ownership and exclusive use of the property on the sale.

Is that what she wants? How will you all decide who uses the property and when? Shifting ownership of the property from your mother to you could create a sense of entitlement that makes battles for prime weekends more intense. Make sure you set ground rules ahead of time with your siblings. Who will pay for the property costs?

Presumably, your mother has been paying the property taxes, utilities, insurance and repairs up to this point. If you kids buy the cottage from her, make sure you have a game plan and that you all agree on how the costs are going to be divvied in advance. Renovations, in particular, can be a source of disagreements.

And while death, cottage capital gains and taxes are all inevitable, keep in mind the fact that divorce is about 50% inevitable right now in this country as well. If you buy the cottage from your mother now and you use it with your families, your share of that property may become family property (for marital and family law purposes) that is divisible with your spouse in the event of a divorce.

Just remember, your mother may be able to avoid or reduce the capital gains tax on the eventual sale of the cottage with the principal residence exemption, but there are other potential costs of selling the cottage to you that need to be considered before a sale occurs.

Read more about capital gains:

• Capital gains tax when selling a rental property
• Do you pay capital gains tax when separating or divorcing?
• Would a senior get a tax credit for selling their house if they move out?

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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