The family cabin is a place to relax and get away from our busy and stressful lives. As the baby boomer generation ages, more and more parents are going to be looking for the most efficient way to pass the family cabin on to the next generation. Unfortunately, the transfer of a recreational property is never as simple as we would like. The purpose of this bulletin is to discuss some of the major issues we address when advising clients on the transfer of their recreational property to the next generation.
Where a cabin is owned jointly between spouses (or owned by one spouse and gifted through the Will/estate to the surviving spouse), there are no tax implications when the first spouse passes away.
However, when the last/surviving spouse dies, there will be a deemed disposition of the cabin for fair market value. A capital gain will be triggered, and taxes will have to be paid on 50% of the capital gain.
Example: Jon and Sally purchased a cabin at the Shuswap in 1998 for $200,000. Jon passes away in 2016, making Sally the sole owner. Sally dies in 2019. At the time of Sally’s death, the cabin’s fair market value is $800,000. In this example, Sally’s estate would have to report a capital gain of $600,000 (proceeds of disposition ($800,000) less the cost of acquisition ($200,000)), and pay tax on 50% of that gain ($300,000).
Our clients often think they can avoid the deemed disposition described above by transferring the cabin into joint ownership with one or more of their adult children. This type of planning is problematic for a number of reasons, and ineffective for tax purposes because of subsection 69(1) of the Income Tax Act (Canada), which treats any transaction between related individuals (i.e. parents and children) as a disposition for fair market value. The parent has to report a disposition as though they have sold the property for its fair market value in their income tax return, and pay tax on 50% of the capital gain.
One strategy to reduce, or eliminate the tax on the deemed disposition triggered at death, or on a transfer to a related person, is to designate the cabin as your principal residence. A cabin can be designated as a principal residence (even if you do not use it as your primary residence) as long as it is “ordinarily inhabited”. Ordinarily inhabited includes living at the cabin for only a short period of time. If you own a home, and a cabin, there are a couple things to be aware of in order to ensure that you benefit as much as possible from this exemption:
- You and your spouse can designate only one of your residences as your principal residence for each year that you owned multiple residential properties. Deciding how to best utilize the principal residence exemption is complicated and often requires that you consider multiple factors, including predictions about whether the remaining residence will increase or decrease in value in the future. You should consult your accountant and possibly a realtor in making this determination;
- Reporting requirements for the principal residence exemption changed in 2016. Prior to 2016, you did not have to report the disposition of a principal residence when such property was fully exempt. Now you are required to report basic information (date of acquisition, proceeds of disposition and description of the property) on your tax return; and
- If your cabin property is large, you may not be able to claim the full principal residence exemption. Generally, the surrounding land in excess of half-hectare (1.24 acres) is deemed not to qualify as part of the principal residence unless the taxpayer can prove that such land is necessary to the continued use and enjoyment of the residence.
If you can adequately address the above, then claiming the principle residence exemption on the cottage is an effective way to transfer/gift the cottage to your children, tax free.
Another strategy to reduce tax payable is to sell the cabin to your child(ren) for fair market value, and structure the transaction so that your child(ren) pay(s) the purchase price over a maximum of five years. This can be done by having your children pay for the cabin with a promissory note that specifies that 20% of the purchase price is repayable each year. In this scenario, your child is required to come up with only 20% of the full amount of the purchase price upfront, and you may be able to use the capital gain reserve as a way of spreading the capital gain (and the associated tax) over a five-year period.
Property Transfer Tax
Aside from the income taxes payable on a transfer to your children, people often overlook the applicability of Property Transfer Tax (“PTT”). PTT is calculated based on the relevant property’s fair market value. If you and your spouse decide to transfer the cabin to one or more of your children, your children will be liable for PTT on the transfer, calculated on the fair market value as follows:
- 1% on the first $200,000 of value;
- 2% on $200,000 to $2,000,000; and
- 3% on > $2,000,000.
A transfer of a recreational residence to a related individual (e.g. child) may be exempt from PTT if it meets the following four criteria:
- Before the transfer, the person transferring the property usually resided on the property on a seasonal basis for recreational purposes;
- The property is classified as residential by BC Assessment, including the land and any improvements on the land;
- The land is 5 hectares or smaller; and
- The property has a fair market value of $275,000 or less.
All four of the above requirements must be satisfied, regardless of what interest you are acquiring in the property. For example, if you are acquiring an interest in your parent’s cabin and the cabin has a fair market value of $600,000, your 33% interest would be worth $200,000. In this case, you would not qualify for the exemption because the fair market value of the entire property exceeds $275,000.
Given these strict requirements, and the price of waterfront property in the Shuswap and other areas of the province, very few people will benefit from this exemption. That said, it can still be useful and is worth keeping top of mind when dealing with recreational properties.
Prior to transferring a recreational property to your children, you should consider having your children sign a Co-ownership Agreement. Alternatively, if you and your siblings inherit a shared interest in the family cabin, it may be in everyones’ best interest to sign one. A Co-ownership Agreement can, and should outline expectations for:
- Expenses- who pays for the utilities, cable, hydro etc.?
- Maintenance- who cuts the lawn and waters the garden?
- Renovations- who pays for the new roof, and what happens if one of the co-owners does not pay their fair share?
- Restrictions on sale- do all parties have to agree to sell, or can the majority force a sale? If the parent(s) continue to have an interest, do they have the final say?
- Right of first refusal- can a co-owner gift their interest in the property to their children, or should the other co-owners have the first right to purchase?
- Use schedule- who gets to use the cabin on long weekends?
A well-drafted Co-ownership Agreement should deal with all of the scenarios contemplated above and include default provisions if one or more of the co-owners is in breach of the agreement.
If you have question about the most practical estate solution for your recreational property, we can help.