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The taxing side of owning vacation property

Overlooking estate matters can cost you. Having a strategy to effectively deal with capital gains taxes, property ownership and control will leave more of your estate to those you care about.

Busy planning your annual trip to your cherished summer retreat? Or perhaps you've just closed the deal on your dream home-away-from-home.

Tax and estate planning is likely the furthest thing from your mind. But it shouldn't be. Owning vacation property brings its own set of financial concerns, especially when it's time to sell or pass it on to your children.

Having a strategy to effectively deal with capital gains taxes, property ownership and control will not only leave more of your estate to those you care about, it will spare them headaches down the road.

Dealing with capital gains

In BC the price of recreational property has soared over the few decades. Many long-time vacation property owners have enjoyed a dramatic increase in the value of their investment.

A more valuable home may do wonders for your net worth, but comes at a price: capital gains taxes. If you've held your property for many years, the capital gains can be significant.

Upon death your assets are disposed of at market value. Say you purchased your vacation home for $200,000 and it's valued today at $800,000 (a modest figure for favoured areas like Whistler or the Sunshine Coast). You're sitting on a $600,000 capital gain. Half of the gain, $300,000, would be subject to tax. If you're in the top tax bracket in BC, you estate could owe as much as 44% of this amount, or $132,000.

That’s significant amount and one that your heirs may not have the resources to pay. It could be devastating if your property with all its cherished memories has to be sold to settle the tax bill.

Here are a few strategies to help ensure that doesn't happen.

1. Stay or get married

Marriage creates an exception which will defer taxes for a time. When you die, ownership of the property can transfer to your spouse, delaying capital gains taxes until his or her death. This "spousal rollover" also keeps the property out of the probate process, potentially saving your estate thousands of dollars in fees. This only delays the issue until your spouse’s death; however, so also consider the following.

2. Track improvements

Keep careful records of any property improvements or renovations. These expenses can be added to what you originally paid, raising your cost base for tax purposes thereby reducing the capital gain.

3. Take advantage of principal residence rules

A principal residence is generally exempt from capital gains taxes. Vacation property can be designated a principal residence, but to qualify you must inhabit it at some point during the year and earning rental income can't be the main motive for ownership.

Foreign real estate can be designated as well. Be aware, however, that American tax laws affecting Canadians holding real estate in the U.S. can be complex, so get professional guidance if you already own or are considering purchasing a home south of the border.

If you're a “family unit” (for example, a couple and minor children) that owns multiple homes, you may only select one property to be your principal residence.  

Compare the capital gains that have accrued on each property and consider designating the one with the larger amount. But remember, any gains that continue to build in the home you don't choose will eventually be taxed.

4. Use your life insurance

A flexible way to cover future taxes that result from selling or transferring your property is through life insurance†. By purchasing last-to-die policies for you and your spouse, there'll be enough funds to pay any capital gains taxes when the survivor passes on. Life insurance benefits are paid out tax-free and are usually received sooner by the beneficiaries than waiting for funds from an estate settlement.

5. Transfer ownership now

If you're older or have health challenges, life insurance may be prohibitively expensive or unavailable. If this is the case, transferring title to your family members now can be a sensible move to minimize taxes.

Gifting or selling the property changes ownership, immediately triggering any capital gains and taxes in your name. But any future gains will be taxed in your children's hands when they eventually sell or transfer title. This strategy works best for properties having only a small amount of capital gains built up, such as a recent purchase.

Bringing your children in as joint owners has similar tax consequences, but still leaves you with a measure of control. It's important to develop a co-ownership agreement to govern each party. The agreement should include establishing a decision-making process, assigning upkeep responsibilities and setting a schedule for sharing the property. It should also outline what happens if an owner defaults on their obligations, becomes incapable or dies.

6. Set up a trust

When setting up a trust to hold your vacation property, you can name your children as beneficiaries. Then, taxes on any capital gains created during the trust's existence will be deferred until they eventually sell or transfer title.

Since you no longer own the property (the trust does), it won't be included in your estate when you die, saving probate costs. Under certain conditions, trusts can be structured to avoid the capital gains tax hit you'll face when you first transfer the property into the trust.

A trust is flexible, leaving you room in deciding how it should operate. For example, you can mandate that you have exclusive use and control over the property while you're alive. Later on, perhaps you'll be less interested in travelling to the lake and may decide to give up possession to other family members. The choice is yours.

One caveat is the "21-year rule". Property held in trust is generally deemed to be disposed of every 21 years. Any capital gains are also taxable every 21 years. If your children are very young when they're made the trust's beneficiaries, the rule may prevent the long-term tax deferral you were hoping they might enjoy.

If you're considering a trust, seek out professional advice. They can be complicated and expensive to set up; however, they can be a powerful estate planning tool when used properly.

Related Resources: The costs of owning cottages and vacation properties (video)

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† Insurance services provided by BlueShore Wealth.

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