Creating a succession plan
Lawyer Peter Lillico's six-point plan
Step 1: Estimating the tax
When estimating the capital gains due on the cottage, there are several on-line resources you can use, including Lillico’s website. You only need to calculate the gain since Dec. 31, 1971 (or since 1981 if the family designated the cottage as the spouse’s principal residence, which was allowed until 1982). If you had already used up your $100,000 lifetime capital gains exemption on other investments before it was snatched away by the government in 1994, and you own an $800,000 historic cottage in Muskoka, the capital gains tax hit could be more than $100,000. (Your own labour on cottage improvements doesn’t count, which seems a bit unfair.) Here’s what the calculation looks like, assuming the property was worth $200,000 in 1971:
Cottage value in 1971: $200,000
Plus capital improvements (for which, of course, you have receipts): +$50,000
Adjusted cost base: $250,000
Today’s value: $800,000
Minus adjusted cost base: - $250,000
Capital gain: $550,000
Amount on which you pay tax (50%): $275,000
Total capital gains tax at top individual rate in Ontario (46%): $126,000
If you already crystallized most of the gains in the mid-1990s in order to use the now-obsolete $100,000 lifetime capital gains exemption and your property hasn’t climbed greatly in value since then, consider transferring the property to your children now, so that the next event triggering significant capital gains will not be until they pass it to their children.
Step 2: Reducing the tax bite
If the value of your cottage has increased much more than the value of your house, it may make sense to designate the cottage as your principal residence and take advantage of the principal residence exemption. To do so, you do not need to occupy the cottage most of the time. Surprisingly, even a few weekends a year at the cottage may qualify it as a principal residence, as long as at least either you, your spouse, or one of your children spent time there. Moreover, don’t overlook a clever loophole that is explained in The Canadian Guide to Will and Estate Planning by John Budd and Douglas Gray. Due to a quirk in the formula for calculating the principal residence exemption, you can also designate your house as your principal residence for one year, and still get a 100 per cent exemption on the gain in the cottage. The book also points out a small wrinkle – that the principal residence exemption only covers about two acres of land around the cottage, and that to include more acreage, you have to prove that it is necessary to your use and enjoyment of the property.
Another useful strategy, according to Lillico, is transferring only perhaps 20 per cent of the cottage to the children each year for five years so that you only include one-fifth of the deemed gain in your income each year and only pay the capital gains tax on the portion transferred each year. This might avoid bumping your income into a higher marginal tax bracket and might also avoid generating an income so high that it would trigger a clawback of Old Age Security. The downside of this approach is that if cottage prices are climbing, you may be required to pay for a new real estate appraisal each of the five years and you will have to have a new deed prepared and registered each time at a cost of about $200.
This article was originally published on May 17, 2004