Handing Down Your Vacation Property
Don’t let a lack of planning spoil the memories.
Whether it’s a cabin, condo or chalet, your home away from home is a treasured escape you enjoy year-in and year-out with friends and family. Now, as another summer winds down, you’re reminded of the day you’ll want to leave that special place to the next generation.
Unfortunately too many property owners fail to plan the transfer of title to their vacation property. In a recent BlueShore Financial survey, over half (56%) admitted to not having a strategy. Overlooking details when handing down a vacation home can create problems, from an unwelcome tax bill to strained family relations.
Start by having an open discussion
Few assets can stir up emotions like a vacation property. That’s why it’s essential to first discuss your desires to transfer title with those affected most, likely your spouse and children.
Although parents may go in with the right intentions, a lack of understanding and the wrong assumptions can lead to conflict and hard feelings. BlueShore Financial’s research found that even when parents have a plan the majority haven’t shared the details with their children.
Asking a few key questions can help ensure a happier outcome for all involved.
- Don’t assume your passion for the property extends to each family member. Is every child interested in owning the home? Some might live too far away to make use of it while others may appreciate receiving cash or other assets instead.
- Like any home, a vacation home represents an ongoing financial obligation. Are you leaving the property to someone who is able to keep up with the taxes, maintenance and other expenses?
- Are there unresolved issues between your heirs that could sabotage your hopes for family harmony? If you and your spouse are acting as peacemakers now, what will happen once you’re out of the picture? Control of a recreational property may offer up yet another reason to fight.
- Take a second look at your retirement readiness and make sure the vacation property is something you can afford to give up in the first place. Are you certain you won’t eventually need the cash the home’s sale could provide?
Timing the transfer
While there’s always the option of transferring ownership of a recreational property through your will, you might choose instead to hand title to your beneficiaries while you’re alive. That way you’ll have the satisfaction of seeing them enjoy the home. That said there are potential drawbacks to weigh.
Transferring title usually means giving up control of the property. And, if your home’s value has run up with the real estate market over the last few years, expect the ownership change to trigger what could be a hefty tax bill for capital gains.
Strategies for dealing with capital gains tax
Capital gains tax is perhaps the biggest financial headache for vacation property owners when transferring title to their heirs.
Under Canada Revenue Agency (CRA) rules, 50% percent of any capital gain is subject to tax at the individual’s marginal rate. A capital gain (or loss) is measured by the difference in the property’s market value and the adjusted cost base, which includes any upgrades or renovations.
If capital gains tax is not properly planned for, owners and their families could wind up paying more than they should. In the worst case beneficiaries could even be forced to sell the vacation home in order to cover the taxes owing.
How can you avoid, offset, or at least defer, capital gains taxes?
1. Roll it to your spouse. If not jointly owned already, one option is to leave your vacation property to your spouse or common law partner, either during your lifetime or in your will. Through this “spousal rollover” any taxes on capital gains can be deferred until their death (earlier if they dispose of the property).
2. Make the transfer gradual. Rather than doing it all at once, you can soften the tax hit by transferring the property in chunks, say 20% each year, which will spread out your tax obligation.
3. Take advantage of the principal residence exemption. As long as earning income isn’t the main motivation for owning your vacation home, the principal residence exemption (PRE) can help you avoid capital gains tax by shielding the price gain on your property. You have the option of declaring a recreation property as your principal residence, even if you live there only some of the time.
The home doesn’t have to be in Canada to be eligible for the PRE, important to know if you have a vacation property south of the border. As a general rule it’s a good idea to seek legal and tax advice if you own a U.S. residence as you may face estate taxes and cross-border issues related to its disposition.
A key restriction is you and your spouse can only claim the PRE on one home which can leave you with a dilemma. If you choose to exempt your vacation property upon transferring ownership, you can’t claim the PRE for your city home for the same period, and vice versa.
Choosing the best course often comes down to comparing the accrued gains and potential for future value increases for each property. You can then see where applying the PRE will protect the most value and capture the greatest tax benefit.
4. Look to life insurance. While it’s often overlooked as wealth transfer tool, life insurance can be used to offset capital gains tax owed by your estate when you transfer a vacation property through your will.
The simplest approach is to buy enough life insurance that at a minimum matches the capital gains taxes owing. Liquidity provided when the policy pays out reduces the risk that your beneficiaries will have to sell the vacation property to come up with the cash needed to settle your estate. Here’s a basic example of how life insurance can help:
Life insurance example
Eileen is a 55-year-old mother of two adult children. Her Whistler cabin, which she would like to pass on to her kids through her will, has increased substantially in value since she bought it, leaving her with a $436,000 capital gain to date. Under CRA rules, 50% or $218,000 of the accrued gain is taxable. At Eileen’s marginal tax rate of just under 46% she’ll owe nearly $100,000 in taxes when the property changes hands.
For a premium of $129 per month, Eileen purchases a $100,000 life insurance policy to match her tax liability on the cabin. By purchasing the policy now while she’s still relatively young, in good health and eligible for coverage, she’s able to minimize her insurance costs.
When she dies, Eileen’s children, the policy’s named beneficiaries, can use the policy’s proceeds to settle her tax bill. If she lives to age 85, for example, Eileen will have paid just over $46,000 in premiums over the years – far less than her capital gains tax owing. In other words, she’ll have spent 46 cents to generate a dollar of tax savings for her estate, allowing her to leave a larger legacy to her children1.
Eileen could consider increasing her insurance coverage to offset future taxes from any further gains in her property’s value, provide funds to help her children with upkeep and maintenance, or help fund an alternate bequest for a child who might not want the vacation home. A larger policy could also cover off other capital gains tax liabilities from her rental property, investment portfolio and other assets, or pay for additional costs associated with the settlement of her estate.
1 Life insurance policy used in this example is a minimum funded universal life policy (Manulife) at standard rates with level premiums. Cost of insurance is $129.06 per month on a $100,000 policy for a 55 year-old female. Marginal tax rate is 45.8% for 2014 (British Columbia).
A general point is that once you transfer title to your vacation home, your obligations end – any future capital gains will be taxed in the recipients’ hands. Relinquishing the property has the added benefit of leaving you with a smaller estate, and in turn, lower probate expenses down the road.
How a trust can help
Using a trust can help you overcome obstacles to transferring ownership of your recreation property.
When you move title to a trust, the trust becomes the owner. But that doesn’t mean you have to surrender control. The trust agreement can let you have a say in the property’s future governance, now or after your death. It can cover a range of issues, from stating how the property is to be shared and managed, to outlining what happens if one of the owners defaults on their commitments. You can also decide when the trust is to be wound down and the property rolled out to the beneficiaries.
Normally when you transfer property to a trust, the CRA presumes the property sold at fair market value and any capital gains will be taxable in your hands when the transfer is made. Happily, if you’re 65 or older, capital gains taxes can be deferred if the property is placed in a living trust like an alter ego or joint partner trust. And, as with an outright gift or sale, transferring property to a trust takes it out of your estate, saving probate fees.
Understand that while a trust can sometimes defer the tax bill, it can’t eliminate it. Trusts are subject to the “21-year rule”. At a minimum, every 21 years a trust is deemed to have sold, its property and capital gains taxes are due unless the property is transferred out beforehand.
Another option to consider in transferring ownership of a recreational property is to create a non-profit corporation that will own the property for the long-term benefit of your family. Under this scenario family members that would have been beneficiaries now become members / shareholders of the non-profit corporation and pay fees as part of their membership. The fees could be used to maintain the property or cover any other expenses. Any family member who chooses not to be a member doesn't have to pay fees, and won't have a right to use the property. There would be no tax to pay on the sale of the property in this case, and the property can remain in the non-profit corporation for multiple generations. Because of the ongoing nature of a corporation, there is no deemed disposition every 21 years, such as in a trust. However, if the property is ever sold and the cash is distributed to family members, there'd be tax to pay on that income in the hands of those family members.
There could be tax to pay on the transfer of the property to a non-profit corporation, unless you use your principal residence exemption to shelter the gain on the transfer. This idea works best when it's expected that the property will remain in the family for at least two or three generations.
The emotional investment you and your family members share in a vacation home can make it one of the most difficult assets to deal with in estate planning. Once you add taxation from rising property values into the mix, leaving your property to your loved ones can be costly if you don’t have the right plan.
A solution is as close as the team of experts at BlueShore Financial. Contact your advisor and let us help you and your heirs, keep creating wonderful memories for years to come.