Our clients, Ron and Sheryl, met with their BDO tax advisor to discuss succession planning for their family cottage. Their intent is for the property to remain in the family after they're gone, and they want to have a plan in place to eventually transfer the ownership to their children. They want to know their options, including what would be the most tax-efficient way to pass the cottage on to their kids.
The couple has owned their Muskoka, Ont. cottage for nearly 19 years. They have two grown children, Leah and Stuart. Ron and Sheryl also own a home in Toronto. Ron, 68, recently retired from his business and Sheryl, 66, continues to work part time. They have some investments, which, along with their other sources of income, provide sufficient cash flow to maintain their lifestyle.
Do you own a cottage property in Canada that you want your children or family members to inherit? Perhaps you have the same questions as Ron and Sheryl. Let's look at what they learned from talking to their BDO advisor.
Tax-efficient options for cottage succession planning
Ron and Sheryl's situation isn't unusual. Cottage owners frequently wish to keep the property within the family after they die. Unfortunately, without careful consideration, the transfer or gift of a cottage to children or family members can create an unexpected income tax burden.
Before deciding to transfer or gift the property to their children, the couple should talk to both children to ensure they feel comfortable inheriting the property. Ron and Sheryl should also consider whether sharing the cottage and its upkeep may create future conflicts between Leah and Stuart.
If there is a concern that transferring ownership of the cottage to Leah and Stuart may ultimately fracture the siblings' relationship, it may be better for Ron and Sheryl to consider selling the cottage to an unrelated buyer instead. In this case, any residual wealth generated from the sale after Ron and Sheryl are gone can be split between their children as part of their estate.
Some of the tax considerations of owning a cottage property, including selling it, are discussed in our Q&A: Tax planning strategies for cottage owners article.
If Ron and Sheryl decide to transfer the cottage to their children, there are several ways to accomplish this. Let's consider the options.
Use a personal trust
A trust separates the control and management of an asset from its ownership. Transferring their cottage to an inter-vivos trust, which is a trust created while Ron and Sheryl are still living, can allow them to gift ownership of their cottage to their children as beneficiaries of the trust. As well, an inter-vivos trust will allow Ron and Sheryl to enjoy the continued use of the cottage. Aside from tax planning, a significant benefit of holding a cottage in an inter-vivos trust is that probate fees can be avoided on death, in provinces and territories where they apply. This is because property held within a trust is not considered to be part of the deceased's estate.
While the use of a trust has many benefits, both for protecting and controlling assets, the underused housing tax (UHT) levied under the Underused Housing Tax Act (UHTA) will need to be considered where the trust owns residential real property situated in Canada.
Is such a situation, the UHTA will cause the owner of record of the real property, which in some provinces is a trustee, to make an annual filing of a UHT return. Where all of the beneficiaries of the trust are Canadian citizens or Canadian residents for immigration purposes, then an exemption from the UHT can be claimed, but a UHT return still needs to be filed. (Please see our How the underused housing tax may affect owners of residential property in Canada and Underused Housing Tax program: Considerations for Canadian corporations, partnerships, and trusts articles for further details about this tax and required filings.)
If a trust is being considered primarily to save probate fees, this savings should be compared to the cost of filing the UHT return. As explained in the articles referenced above, although many trusts holding real property will be exempt from UHT (which is a 1% tax of the value of the real property), this will depend on many factors. Please consult your BDO advisor prior to setting up a trust to hold Canadian real property to better understand the risks and benefits.
If Ron and Sheryl transfer the cottage to an inter-vivos family trust, there will be a deemed disposition at fair market value at that time. If their cottage increased in value from the time they purchased it, there likely will be a taxable capital gain realized on this transfer. However, Ron and Sheryl may be able to shelter a portion of this gain from income tax by using their principal residence exemption.
Since the couple also owns a home in the city, they will need to decide whether they might benefit from using their principal residence exemption on the deemed disposition of their cottage, waiting to use it on a future disposition of their city home, or claiming a partial exemption on the disposition of each property. Only one property can be designated as their principal residence for each year that they own both properties. As a result, they'll need to consider many factors when deciding which years (if any) to designate the cottage as their principal residence, such as which property they expect will ultimately have the higher average annual capital gain over the period it is owned, and when they expect the capital gain on each property to be triggered for tax purposes.
Ron and Sheryl must also keep in mind that every 21 years, there will be a deemed disposition of the trust property at its fair market value. This means taxes will have to be paid on the accrued gain at that time if the trust still owns the property.
A way to circumvent both deemed disposition rules is to transfer the cottage to a joint spousal trust (discussed below).
Another issue to think about when considering using a trust is the new reporting requirements that are imposed on trusts, starting with December 31, 2023 trust year-ends. This reporting will require filing an annual T3 trust return, which will include detailed disclosures to the Canada Revenue Agency of personal information of the settlor, trustees, beneficiaries and any other person who can influence trustee decisions regarding the appointment of income or capital of the trust. For further information, please see our article New trust reporting requirements are coming.
Principal residence exemption and real property held in a trust
Legislative changes made in 2016, which were designed to close loopholes surrounding the use of the principal residence exemption, could impact Ron and Sheryl's decision on whether to transfer the cottage to a trust. As a result of these changes, if the cottage is subsequently sold by the trust, rather than distributed to Leah and Stuart, there will be a disposition for income tax purposes and taxes will become payable. In this case, the trust won't be eligible to claim the principal residence exemption on any of the gains that have accrued since the cottage was transferred to the trust. This is because, effective for taxation years that begin after 2016, only certain personal trusts are eligible to claim the principal residence exemption.
Eligible trusts include:
- An alter ego trust, spousal trust (either inter-vivos or testamentary), joint spousal trust, or certain other trusts for the exclusive benefit of the settlor during the settlor's lifetime.
- A qualified disability trust, provided certain conditions are met.
- An orphan trust (the specified beneficiary is a minor whose parents are both deceased).
For a personal trust that no longer qualifies as an eligible trust after 2016, but that existed prior to 2016, certain grandfathering provisions will allow the principal residence exemption to be applied under specific conditions, and only to the gains accrued on the property up to Dec. 31, 2016. Where a property is disposed of in 2017 or later, any gain that accrued after Dec. 31, 2016 will not be eligible for the principal residence exemption.
Should Ron and Sheryl consider a joint spousal trust?
Since both Ron and Sheryl are over the age of 65, they're able to transfer the ownership of their cottage to a joint spousal trust without triggering the application of the deemed disposition rules discussed above.
The terms of the trust will have to provide that they have a right to the use and enjoyment of the cottage, and Leah and Stuart will be named as capital beneficiaries of the trust. When the last of either Ron or Sheryl dies, their children will be transferred ownership of the cottage and there will be a deemed disposition of the cottage at that time. The trust will then pay tax on any increase in value over the cottage's adjusted cost base (ACB).
Since a joint spousal trust is an eligible trust for the purposes of claiming the principal residence exemption, and assuming the trust meets certain other criteria, it can use the principal residence exemption (if available) to reduce the tax on the accrued gains realized on the death of the last surviving spouse.
What about a testamentary trust?
To pass ownership of the cottage to their children after they die, Ron and Sheryl may also consider the use of a testamentary trust, which is a trust that is generally created on death.
When the first spouse dies, the cottage can be transferred directly to the surviving spouse (or to a testamentary spousal trust) on a tax-free basis. When the surviving spouse dies, the cottage will be deemed to be disposed of at fair market value and their estate (or the spousal trust) will pay tax on the accrued gain. Should there be a taxable gain on death, the principal residence exemption may be used to shelter all or a portion of that gain, if available. After death, the cottage will be an asset of the testamentary trust, with the couple's children as beneficiaries.
However, a testamentary trust may not be as tax effective as transferring the cottage to their children on death. This is because it doesn't qualify as an eligible trust for the purposes of the principal residence exemption. As a result, any gains that accrue on the property between the time it's transferred to the trust and its eventual sale will be fully taxable within the trust. In this case, it may be more beneficial to transfer the property to Leah and Stuart following the death of their last surviving parent rather than to a testamentary trust, unless the couple has other non-tax reasons for wanting to prevent their children from owning the cottage directly. These reasons may include protecting the property in the event of a marriage breakdown or from creditors.
If Ron and Sheryl do decide to bequeath the cottage to Leah and Stuart after they die, they may wish to consider purchasing a life insurance policy to pay for the taxes that will become payable by the trust on the deemed disposition at death.
Joint tenancy with the right of survivorship
Another option for Ron and Sheryl to consider is transferring ownership of the cottage directly to their children during their lifetime. They can accomplish this by transferring title into joint ownership with the right of survivorship. When one owner dies, the cottage simply transfers into the hands of the other joint owner(s), thereby potentially bypassing the estate and thus avoiding probate. In Quebec, the concept of undivided co-ownership, usufruct, or right of use can be used. Note that usufruct and right of use are treated like trusts for tax purposes.
The transfer of a cottage into joint tenancy—or in Quebec, in co-ownership—will constitute a partial disposition for tax purposes and will generally trigger the realization of a capital gain if the property has increased in value. An exception to this is if you transfer joint tenancy to your spouse.
There may be future implications to claiming the principal residence exemption when this option is used. In addition, there will be legal and other implications when entering into a joint tenancy agreement with their children since Ron and Sheryl will no longer be the sole owners of the property.
Sell the cottage to the children
Ron and Sheryl can also consider selling the cottage to their children while they're still alive. If they do, there will be a disposition for income tax purposes at the time of sale. The capital gain will be calculated based on the fair market value of the property regardless of the selling price since the sale is considered to take place between non-arm's length parties. If Ron and Sheryl sell the cottage to their children for less than fair market value, they will still pay tax as though they received fair market value and their children will have an ACB equal to the amount they paid, possibly resulting in double taxation.
Another option for Ron and Sheryl to consider is to spread out the gain on the sale over five years, which may allow them to use the capital gains reserve. This will spread out the taxation of the capital gain over time rather than having to pay tax on it all in one year.
BDO can help you understand your options
There are many options for keeping a cottage in the family for future generations to enjoy. While not always easy, considering both the emotional and financial aspects of transferring or gifting a cottage to your children or family members will go a long way to ensuring a smooth transition.
Speak to your BDO advisor if you're thinking about transitioning your cottage or vacation property to your children or family members.
The information in this publication is current as of October 30, 2023.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.