Since the recent launch of our new guide – Passing on the Cottage: A Guide for Families, I’ve had a number of questions about transfers where one or more children want ownership of a cottage while others don’t want to – or can’t – keep their share.
This is a common situation for a variety of reasons outlined in the guide. For example, some family members may not have the money to hold onto their share of the cottage. Or perhaps they’ve moved away or just aren’t interested in owning it.
Normally, the children who aren’t participating in ownership will be compensated for their share of the value of the property. But this has to be done carefully to ensure fairness, preserve family harmony and avoid paying excess capital gains tax. To achieve a successful outcome, it’s critical to have in depth family discussions to understand everyone’s position on the cottage and explore various options.
The ideal situation in a transfer is when the parents have enough assets to cover both the capital gains owed on the property and compensate the non-owning siblings for their share of its value. If this is done through the parents’ will, the siblings who aren’t interested in owning the property are bequeathed a greater share of other assets in the estate.
Alternatively, the parents can gift the cottage to their children during their lifetime. However, this has to be done the right way to avoid paying additional capital gains tax. If the cottage is sold to the children for $1, the tax authorities will deem the cost base for the new owners to be $1. If that happens, the parents will pay capital gains tax on the transfer based on the fair market value and the children who take it over will pay tax on those same gains all over again when they sell it.
A better way is for the children to give the parents a promissory note in exchange for “selling” the cottage to them at its fair market price. While the note is deemed payable by the new owners on demand, no money actually changes hands. Instead, the promissory note is forgiven in the parents’ will. The sale price in the note becomes the starting point for future capital gains to the children (i.e. it becomes the children’s cost base for their taxes) and the parents can spread the payment of taxes on existing gains over five years, using what’s known as a capital reserve.
Again, in gifting the cottage, the parents would ideally have enough assets to compensate the non-owning children for their share of the cottage at its fair market value, pay the capital gains and have enough left over to live on comfortably.
If this isn’t the case, there are a couple of possible scenarios. In the first, the new owners buy out their other siblings if they have enough money to do so. In the second, the non-owning siblings are equalized in the parents’ will.
In the latter scenario, the non-owning siblings would each be paid an amount equal to the value of the cottage from their parent’s estate first, then any residual value in the estate would be divided equally among all the children. In order to compensate the non-owning siblings for the fact that they are getting their inheritance later, the amount is often grossed-up by a certain percentage per year from the time of the cottage transfer to the time of the last parent’s passing. This recognizes the time value of money.
How to fairly calculate this extra sum? I think the best way is to imagine that the cottage had been sold at the time it was transferred to the interested children. If this had been the case, the money from the sale would have flowed into the parents’ investment portfolio. Therefore, an appropriate way to adjust the non-owning children’s share would be to apply the rate of return that the parent’s investment portfolio actually earned between the time of the cottage transfer and the last parent’s death.
A good financial planner can help the parents project their balance sheet into the future, given their income and spending, to see if there will be enough left over in their estate to properly equalize the non-owning children. Unfortunately, for some families the reality is that there won’t be enough money to keep the cottage, compensate the non-owning siblings and pay the capital gains tax. In this case, the cottage may have to be sold – an eventuality that can stir up strong feelings within a family.
To deal with this and other potential pitfalls in transferring a cottage, I repeat how important it is to have early and comprehensive family discussions with the guidance of experienced advisors. To get more advice on passing on your cottage, please download our free guide and don’t hesitate to contact us if you think we can help.