If you’re like me, your cottage is at the heart of your family life. It’s a place where everyone can get together, share good times and make memories.

But all too often, a cottage becomes a burden when it comes time to pass it along to the next generation. There are difficult decisions to be made about who is going to own it, and how it’s going to be managed and shared.

And there are expenses. Those expenses start with the capital gains tax. In fact, tax is often one of the biggest stumbling blocks when it comes passing on a cottage.

Real estate almost always rises in value over the years. When a property is sold or transferred upon the death of the owner, half of the increase in value is subject to capital gains tax.

An exception is made when the property is left to the owner’s spouse. In that case, it’s transferred tax free. Capital gains tax is ultimately payable when the surviving spouse sells the property, or transfers it upon his or her death—typically to the children.

No capital gains tax on principal residence

Now, there is no capital gains tax to be paid on a property that is designated as your principal residence. Most people designate their house in the city as their principal residence. However, in some situations, it may make sense to designate the cottage as your principal residence.

It’s fairly easy to meet the tax man’s definition of what qualifies as a principal residence. The dwelling must have been inhabited by the family during any part of a year for which the exemption is being claimed.

The decision of whether to designate the city home or cottage will depend on their relative increase in value in the years they were owned. And you may want to split the exemption – using it to reduce taxes on the city home in some years, and the cottage in others.

Before we talk about calculating the capital gains tax, let’s take a look at a bit of history.

The tax was first introduced in 1972. Until the end of 1981, each spouse could designate a separate property as a principal residence – so one could take the city home and the other could take the cottage. As of 1982, a couple can designate only one home as their principal residence.

An example of how the tax applies

Now, let’s look at the case of a Montreal couple that purchased house in the city for $22,000 in 1955. In 1964, our couple bought a cottage on a lake in the Laurentians for $20,000.

By the end of 1981, when they could designate only one property as their principal residence, the value of the house and cottage had leaped to $180,000 and $80,000.

In 2017, they decided to transfer ownership of the property to their children. The couple got a professional appraisal of both properties and learned the city house was worth $800,000 and the cottage was worth $500,000.

There is no capital gains tax applicable between 1972 and 1981 with the husband designating the city house as his principal residence and the wife designating the cottage as her principal residence.

So, in 2017, the capital gain on the city house is $620,000, while on the cottage it is $420,000. In this case, it makes sense to designate the city house as the couple’s principal residence from 1982 onward.

One half of the $420,000 gain on the cottage is taxable.  Given that the property is jointly owned by spouses, the $210,000 taxable gain will be split evenly between them. This gain is taxed at the couple’s respective marginal tax rates. The highest combined tax liability would be about $105,000.  And decrease depending on the couple’s taxation rates.

Points to remember about capital gains

There are a few important points to remember about the capital gains tax. The first is you can’t avoid it by gifting the cottage to your children. And you can’t reduce it by selling it to them at a low price. Ottawa charges the tax on the fair market value of the property, regardless of what price you and your children agree upon.

Another thing to remember is that renovations or improvements such as an addition, a deck or a boathouse can decrease the capital gain. So, it’s a good practice to keep records of all improvements to your cottage.

Finally, the capital gains tax can become a critical issue if one or more of your children decides to opt out of owning the cottage. At that point, the siblings who want to keep the property will typically buy out those who are opting out. But if they can’t afford to pay them their share, plus the tax liability, then the cottage may have to be sold.

This unfortunate outcome almost certainly will produce bitterness between the would-be owners and the opted-out siblings.

Many other issues to consider

Beyond this and other capital gains considerations, there are many other issues to think about when it comes to passing on your cottage.

That’s why it’s so important to have a frank family discussion and come up with a plan as early as possible. You should then make sure your wishes are accurately reflected in your will.

As you go through the process, you should get financial planning and tax advice from experienced professionals.

To get you started, I’ve prepared a free guide that provides a lot of great details and examples. I encourage you to contact me to get your copy.

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