Peter Lillico, of Lillico Bazuk Galloway Halka in Peterborough, Ont., who is an expert in the legal aspects of cottage succession planning, recommends a sweet, innovative strategy for keeping the cottage in the family: a joint partner trust (JPT) combined with a sprinkling inheritance trust (SIT). Here’s how it works: if you and your spouse are both 65 years or older, you can transfer the cottage into a JPT without triggering the capital gains tax, even if the cottage is not your principal residence. You both share responsibility and control of the cottage, and, when one of you dies, ownership transfers to the other, who becomes the sole trustee, again without triggering capital gains or probate taxes.
The surviving spouse can name one or more co-trustees, usually one or more of the children, to help make decisions, a mechanism that can also protect the cottage from a potential predatory remarriage.
Death of the surviving spouse triggers the termination of the JPT and the start of the SIT. At this point, capital gains tax is owed, just as it would have been had the cottage stayed in the individual names rather than going into the trust. The adjusted cost base is the same as if it were in the spouses’ names.
While the cottage is in the JPT, the parents (you and your spouse) typically will designate the trustees of the SIT (likely your children) and a pool of potential beneficiaries (children and grandchildren). Then the SIT trustees decide whether all of the potential beneficiaries will inherit the cottage, or, more likely, will select the most appropriate candidates from among the pool.
This is one of the main advantages of the sprinkling trust: you are not obliged to transfer ownership to your beneficiaries equally. “Most trusts (and wills) provide for equal distribution of assets among all children upon death,” Lillico explains. “The sprinkling trust, by design, provides more flexibility, so as to exclude a child who doesn’t want cottage ownership, or can’t afford to share the expenses, or refuses to play by the same rules as the other beneficiary children.”
Once the sprinkling trust kicks in, its trustees have up to 21 years to decide who will inherit ownership. While it is in the trust, the cottage is sheltered from creditor claims against all the beneficiaries, and it can’t be included in a division of family assets in the event of marital breakdown. The drawbacks? Trusts have to file annual income tax returns, though the income will likely be nil (you will have to claim any rental income). There’s the legal cost for a lawyer to develop the trusts, but that will be much less than the probate tax savings. The good news is that the pros outweigh the cons.
Before the 21st anniversary of the trust, when there is a mandatory deemed disposition of assets out of the trust, the trustees must make a decision: they can pay the capital gains tax on the increase in the value of the cottage since tax was last paid at the termination of the JPT, and then reset the trust for another 21 years. Or they can designate the beneficiaries and distribute the property out of the trust, in which case the trust no longer holds property with an accrued gain, and so no capital gains tax is owed. In fact, the next time capital gains tax will be paid is when the beneficiaries sell, die, or choose to pass the cottage on to another family member. The trustees can even decide to skip a generation and designate one or more of the grandkids as beneficiaries, deferring the tax liability for yet another generation. (Keep in mind that when the cottage is no longer held in trust, it loses its trust protection from creditor and marital claims.)
Once the cottage is in the SIT, you have some breathing space—21 years— to make your decision about who the beneficiaries will be. So there’s no excuse for missing its anniversary. If you do, prepare to shell out the capital gains tax. The Canada Revenue Agency will likely show no mercy.