As a Canadian accounting firm, we understand that transferring family cottages can be both a sentimental and financially complex process. When dealing with a property that has significantly appreciated in value over the years, it’s important to strategize effectively to minimize tax burdens and ensure smooth ownership transfer. Here, we outline a strategic approach in buying family cottage. In this example, we assume the cottage has a fair market value of $1.3 million, originally purchased for $50,000 many, many years ago.
The Strategy: Gifting with a Promissory Note
Step 1: Gifting the Property
Parents can transfer ownership of the cottage to their children as a gift. Although there may be no financial exchange at the time of transfer, it is still treated as a disposition at fair market value, which could trigger a capital gain.
Step 2: Taking Back a Promissory Note
In return for the gift, the parents take back a promissory note from the children. This note represents the $1.3 million fair market value of the property and can be structured to be forgiven upon the parents’ death.
Step 3: Managing the Capital Gain
The capital gain on the property is $1.25 million ($1.3 million fair market value minus $50,000 original purchase price). Instead of recognizing this entire gain at once, the children can take a reserve on the gain and claim it over five years. This means the gain will be recognized in the parents’ income at $250,000 per year.
Step 4: Tax Implications
Under the current tax rules, recognizing $250,000 per year falls below the threshold for the new inclusion rate of one-third. Consequently, it can be taxed at the old inclusion rate of 50%. This results in a more favorable tax treatment for the parents. It does mean that the taxes still need to be paid now (or rather over five years taking the reserve approach). This would need to be done from other assets/cash resources in the parents estate. Variations of this approach can be taking some cash now, however this will generally effect the calculation of the reserve/capital gain recognition.
Advantages of This Strategy
- Gradual Tax Payment
By spreading the capital gain over five years, the tax liability is managed more effectively. This approach avoids a large, one-time tax bill, making the financial impact more manageable. - Ownership Transfer While Parents Are Alive
Transferring the cottage to children while parents are alive allows them to manage the property together with guidance, promoting family unity and preserving traditions. - Avoidance of Probate Taxes/Fees
Transferring the cottage out of the parents’ estate means it won’t be subject to probate taxes and fees when they pass away. This can lead to substantial savings and make the estate settlement process simpler. - Preserving Family Legacy
This method allows the family to keep the cottage within the family, ensuring it remains a cherished gathering place for future generations.
Conclusion
Transferring a family cottage can be a rewarding but intricate process. Gifting the property with a promissory note helps parents manage capital gains tax and transfer ownership to their children during their lifetime. This strategic approach in buying cottage not only minimizes tax burdens but also fosters smoother transitions and preserves the family legacy.
As noted, there can be variations to this strategy but it is specific to each situation. This is a general example of advice we might offer a corporate client when structuring a family cottage buyout. However, it may not apply in all cases, especially if there aren’t enough funds to cover taxes on the transfer. We recommend consulting an advisor for guidance on your specific situation.
Virtual Heights Accounting provides accounting and tax services for small businesses and not-for-profits in Canada. We focus on reducing paperwork and helping clients avoid surprise tax bills. Please remember, this is general advice and may not apply to every situation. Always consult a professional for personalized advice.
