Taxes

Transferring the Family Cottage: Tax Issues

April 18, 2011

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In today’s post Mark Goodfield, a professional accountant and the writer behind the excellent Blunt Bean Blog, continues the series on estate planning issues surrounding the family cottage. Click here for Part 1 of the series.

In my first blog in this three part series on transferring the family cottage, I discussed the fact you can only designate one property as a principal residence per family after 1981. In order to explore the income tax implications associated with transferring ownership of a cottage, I will assume both a city residence and a cottage have been purchased subsequent to 1981 and I will assume that the principal residence exemption has been fully allocated to your city home and the cottage will be the taxable property.

Many parents want to transfer their cottage to their children while they are alive, however, any gift or sale to their children will result in a deemed capital gain equal to the fair market value (“FMV”) of the cottage less the original cost of the cottage, plus any renovations to the cottage. Consequently, a transfer while the owner-parent(s) is/ are alive will create an income tax liability where there is an unrealized capital gain.

Alternatively, where a cottage is not transferred during one of the parent’s lifetime and the cottage is left to the surviving spouse or common-law partner; there are no income tax issues until the death of the surviving spouse/partner. However, upon the death of the surviving spouse/partner, there will be a deemed capital gain, calculated exactly as noted above. This deemed capital gain must be reported on the terminal (final) tax return of the deceased spouse/partner.

Whether a gift or transfer of the cottage is made during your lifetime, or the property transfers to your children through your will, you will have the same income tax issue, a deemed disposition with a capital gain equal to the FMV of the cottage less its cost.

It is my understanding that all provinces with the exception of Alberta, Saskatchewan and parts of rural Nova Scotia have land transfer taxes that would be applicable on any type of cottage transfer. You should confirm whether land transfer tax is applicable in your province with your real estate lawyer

So, are there any strategies to mitigate or alleviate the income tax issue noted above? In my opinion, other than buying life insurance to cover the income tax liability, most strategies are essentially ineffectual income tax wise as they only defer or partially mitigate the income tax issue. In my final blog installment of this series, I will summarize the income tax planning options available to transfer the family cottage.

Transferring the Family Cottage: There is No Panacea

April 17, 2011

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Today’s guest post is Part 1 of a 3-part series on estate planning issues surrounding the family cottage, courtesy of Mark Goodfield, a professional accountant who writes the The Blunt Bean Counter Blog. Mark covers accounting, tax and wealth management issues on his blog and if you haven’t checked out his site, please do so. It is excellent. Now, over to Mark…

This is the first blog in a three part series on transferring the family cottage. Today’s blog will deal with the historical nature of the income tax rules, while the second blog will deal with the income tax implications of transferring or gifting a cottage and finally in the third blog, I will discuss alternative income tax planning opportunities that may mitigate or defer income tax upon the transfer of a family cottage.

Canadians love their cottages. They are willing to put up with three hour drives, traffic jams, never ending repairs and maintenance and constant hosting duties for their piece of tranquility by the lake. However, I would suggest the family cottage is one of the most problematic assets for income tax planning purposes, let alone the inherent family politics that are sure to arise.

For purposes of this blog, I will just assume away the family politics issue. I will assume the children will each grab a beer, sit down at a table and work out a cottage sharing schedule to everyone’s satisfaction and while they are at it, agree on how they will share the future ownership of the cottage when their parents transfer the cottage or pass away. I would say a very realistic situation in Canada, not!!!

Let’s also dismiss any illusions some may harbor that they can plan around the taxation issues related to cottages or even avoid them entirely. I can tell you outright, there is no magical solution to solving the income tax issues in regards to a family cottage, just ways to mitigate or defer the issues. Many cottages were purchased years ago and have large unrealized capital gains.

So let’s start by taking a step back in time. Prior to 1981, each spouse could designate their own principal residence (“PR”) which, in most cases, made the income tax implications of disposing or gifting a family cottage a null and void issue. The principal residence exemption (“PRE”) in the Income Tax Act essentially eliminated any capital gain realized when a personal use property was sold or transferred. Families that had a home in the city and a cottage in the country typically did not have to pay tax on any capital gains realized on either property when sold or gifted.

However, for any year after 1981, a family unit (generally considered to be the taxpayer, his or his spouse or common-law partner and unmarried minor children) can only designate one property between them for purposes of the PRE. Although the designation of a property as a PR is a yearly designation, it is only made when there is an actual disposition of a home. For example, if you owned and lived in both a cottage and a house between 2001 and 2011 and sold them both in 2011, you could choose to designate your cottage as your PR for 2001 to 2003 and your house from 2004 to 2011 or any other permutation plus one year (the CRA provides a bonus year because they are just a giving agency :)).

In order to decide which property to designate for which years after 1981, it is always necessary to determine whether there is a larger gain per year on your cottage or your home in the city. Once that determination is made, in most cases it makes sense to designate the property with the larger gain per year as your personal residence for purposes of the PRE.

Click here to continue to the next post in the series on income tax issues surrounding the transfer of a cottage.

Jack Mintz on Family Taxation

March 31, 2011

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In an article titled Taxing Families: Does the System Need an Overhaul? that appeared in a publication put out by the Institute of Marriage and Family Canada, Prof. Jack Mintz of the University of Calgary argues that our current tax system is unfair to families with one working parent. Prof. Mintz addresses the criticism that one-income families don’t incur some significant expenses that two-income families do such as childcare. He acknowledges that the criticism has some merit but can be addressed by making adjustments to the tax system. One suggestion he makes is to adjust the personal exemption downwards for the stay-at-home spouse and better recognizing the costs incurred in earning a living.

None of the problems associated with family taxation are insurmountable. The basic aim is to achieve efficiency and fairness under the tax system. It is impossible to see how limiting taxation to individual taxation supports these principles.

Nine industrial countries apply the family taxation principle. The French and Portuguese systems aggregate family income but explicitly allow for family size to reduce tax payments. The Czech Republic, Germany, Ireland, Luxembourg, Poland, Switzerland and the United States allow family members to file jointly and split income. Other industrialized countries rely primarily on individual taxation but often allow for family tax principles such as the transferability of deductions and credits or joint filing or splitting of income of some sort.

Prof. Mintz goes on to propose three ideas for implementing a system of taxing families. Income splitting is one of them but Prof. Mintz says that while it may be the simplest, it does not address criticisms about equitable treatment of families.