Planning ahead for taxes, ownership and legacy of your family’s vacation property

Whether you sell or gift the property during your lifetime or own it when you die, you’ll be taxed on any increase in the property’s value since your acquired it. In some cases, such as at death or when gifting the property, the government treats the property as if it was sold at fair market value, even if no money changes hands. The main exception is if the property is gifted to a spouse or partner, in which case the property is deemed to automatically “roll over” to the other spouse or partner, so no gain will be immediately reportable until the second spouse or partner either dies or sells it.

To calculate the capital gain, you subtract the adjusted cost base (ACB) from the proceeds of disposition, which is generally the property’s fair market value. Many people assume the ACB is just the original purchase price, but it can include certain eligible costs, like certain legal fees, land transfer tax and the cost of permanent improvements such as a new roof, dock or addition. It’s worth keeping good records and receipts of any eligible costs, because they may help you lower your future tax bill by reducing the ultimate gain on sale.

Here are some tax planning strategies that may either permanently avoid the capital gains tax or defer paying it as long as possible.

Principal residence exemption

If your vacation property qualifies, you may be able to use the principal residence exemption (PRE) to avoid paying capital gains tax. Since 1982, only one property can be designated as a principal residence in a year by a couple. If a couple owns both a primary home and a vacation home, they must choose which to designate as a principal residence when the first one is sold.

Life insurance 

Another possibility to deal with the ultimate tax liability upon the last-to-die of you and your spouse or partner is to purchase a permanent life insurance policy. The payout from the policy can help the estate cover the capital gains tax without having to sell the property. The cost of the insurance policy will depend on a variety of factors, including age, health and smoking status of the insured. You should consult with a licensed life insurance advisor to determine if insurance is right for you.

Should you use a corporation or trust?

It’s generally not advisable to hold a vacation property inside a corporation, because using it for personal enjoyment could result in a taxable shareholder benefit each year.

Instead, a trust may be a better option. It can be used to avoid tax triggered when the property owner dies because the trust, not the owner, holds the property.

There are some issues to consider, though:

• Most trusts can no longer claim the PRE.
• Transferring an already-appreciated property to a trust may trigger immediate capital gains tax.
• Every 21 years, a trust is deemed to dispose of its assets. Either the gain is taxed in the trust at that time, or the property may be distributed to the trust’s beneficiaries at the tax cost of the property, which allows the beneficiaries to defer paying any capital gains tax until they die or dispose of the property themselves. 

When someone dies, most provinces charge an estate administration tax — also called probate fees — based on the value of the assets passed through the estate.

One way to reduce these fees is to register the property in joint tenancy with right of survivorship. While this may be a good solution for spouses or partners, it’s generally not a good idea to add adult children to joint ownership, as it could cause many problems down the road. Be sure to seek legal advice before moving the property into joint ownership.

Using trusts to hold vacation property can also help to avoid probate fees upon death, since property held inside the trust is generally not be included in the value of your estate.

If you plan to leave your vacation property to your children or other loved ones, it’s important to go beyond just the tax implications.

Start by asking if any or all of your children are actually interested in the property. If you do decide to gift or leave the property to more than one person, consider setting up a formal cottage sharing agreement to avoid future conflict.

You may also want to put aside funds to cover future costs, including maintenance, property taxes and even income taxes upon your death. One way to do this is to contribute amounts regularly to a sinking fund —sometimes called a “reserve fund” — that’s intended to grow to the estimated future amount of these costs. Life insurance can also be used to cover these costs in the future.

Planning for the future of your vacation property involves financial, legal and emotional decisions. The right approach depends on your goals and your family’s needs. Be sure to consult with professional legal, tax and insurance advisors to review and implement strategies that are appropriate in your particular circumstances.