The taxing side of 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.
Maybe you're getting ready for a summer trip to your lakeside cottage. Or 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.
A common dream
Like all real estate in British Columbia, the price of recreational property has soared over the last decade. Many long-time vacation property owners have enjoyed a dramatic increase in the value of their investment.
In a Royal LePage survey, 59% of British Columbians believed a cottage was a good long-term investment. With BC's growing popularity as a place to live, retire and play, the fundamentals are in place to send prices even higher.
Dealing with capital gains
A more valuable home may do wonders for your net worth, but your fatter wallet 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 $500,000 (a modest figure for favoured areas like Whistler or the Sunshine Coast). You're sitting on a $300,000 capital gain. Half of the gain, $150,000, 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 $66,000.
What if your heirs don't have the resources to pay? It would be a tragedy 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.
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 any 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.
Since 1982, 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. This leaves an important decision: should you choose your cottage or your home in the city?
The key issue is to compare the capital gains that have accrued on each property. 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 can be prohibitively expensive; you may even be uninsurable. So, if life insurance isn't an option, 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. It can be a powerful estate planning tool when used properly.