Tax strategies for cottage succession

Many Canadians are concerned about how they can transfer a cottage to the next generation in a tax-efficient manner. With the new capital gains inclusion rate in effect, this is likely even more of a concern for many of your clients. This article will discuss the succession planning options available. While there are several strategies to consider, there are also general pitfalls that could apply to these transfers.

Why selling for less than fair market value isn’t fair

In many cases, an adult child doesn’t have the money required to buy the family cottage from their parents. If the parents don’t need the money to fund retirement, they might consider selling the cottage to the child for nominal value, or an amount substantially lower than fair market value (FMV). This is problematic from a tax standpoint, as it may result in double taxation.

Here’s why. For tax purposes, regardless of the price when parents sell the cottage, they’re required to pay tax on the capital gain, calculated as the difference between the property’s adjusted cost base (ACB) and FMV. The child’s ACB is determined by the purchase price, which may lead to the child paying tax on a capital gain when the child sells the property — tax the parents had already paid.

Let’s assume Michael sold the family cottage to his daughter, Jennifer, for $1 when the cottage had an FMV of $1 million and an ACB of $500,000. Regardless of the purchase price, Michael’s capital gain is the same: $500,000. His tax liability would be $156,133 (see Table 1).

Table 1: Parent’s tax liability on cottage sale

* Assumes top personal tax rate for Ontario and that Michael cannot use the principal residence exemption.

Selling the property to Jennifer for $1 results in her ACB being $1 rather than the property’s FMV. If she sells the property in the future for $2 million, she’ll have a substantial capital gain — almost two million dollars (see Table 2).

Table 2: Child’s tax liability on cottage sale

* Assumes top personal tax rate for Ontario and that Jennifer cannot use the principal residence exemption.

By selling the cottage to Jennifer for $1, Michael assumed he was helping her, but instead he has done her a disservice. If she were to sell the property for $2 million, she’ll be subject to a capital gain of $1,999,999. Further, this results in double taxation on Michael’s capital gain of $500,000.

What other options are available?

Gifting the cottage

Michael can gift the cottage to Jennifer instead. He’ll pay capital gains tax on the difference between the ACB and FMV of the cottage as he did above. The benefit is that Jennifer’s ACB will now be the cottage’s FMV. As a result, if she sells the cottage for $2 million, her capital gains tax will be substantially lower than if she bought the cottage for $1 (see Table 3).

Table 3: Child’s tax liability on gift received

* Assumes top personal tax rate for Ontario and that Jennifer cannot use the principal residence exemption.

Using the capital gains reserve

Gifting the cottage is a better option for Jennifer, but Michael still must pay capital gains tax of $156,133, which is a substantial amount to pay in one year. Michael may want to consider using the capital gains reserve as a way of spreading the capital gain (and resulting tax liability) over time. As long as Michael doesn’t receive the full proceeds of the cottage sale in any one year, the Income Tax Act allows him to spread the capital gain on the sale over a maximum of five years. This can allow Michael to keep the annual capital gain below $250,000 (assuming he doesn’t realize any other gains in the year) and it allows him to take advantage of the 50% inclusion rate.

To accomplish this, Michael would sell the cottage at FMV, and Jennifer would pay for it with a promissory note (which can later be forgiven — more on that below). The promissory note must be structured so that Michael doesn’t collect more than 20% of the sale proceeds each year over the next five years.

In this situation, Jennifer isn’t required to come up with the money to purchase the cottage (assuming the promissory note is forgiven), and, since no money changes hands, Michael can spread the capital gain over a maximum of five years.

CRA’s position is that a reasonable reserve may be determined by the following formula:

Reserve = (Capital gain ÷ proceeds of disposition) × amount payable after year’s end

Reserve calculations for this case are shown in Table 4.

Table 4: Calculating the reserve

Table 5 shows an example of how the capital gains reserve would work if Michael sold the property to Jennifer in 2024 and is able to take advantage of the capital gains reserve.

Table 5: Using capital gains reserve to spread tax liability over five years

Since the annual capital gain is less than $250,000, instead of a tax liability in one year of $156,133, Michael can benefit from a 50% inclusion rate on the annual capital gain, which allows him to reduce his overall tax liability by $22,308.

It’s important to note that Michael will realize one-fifth of the capital gain each year over five years regardless of whether he collects the money from Jennifer or not. In his will, Michael can forgive the promissory note, so Jennifer isn’t required to come up with the money to purchase the cottage. If Michael passes away before the full amount of the capital gain has been realized, the balance will be taxable in his terminal return.

So far, we have talked about the capital gains reserve being used with a cottage, but it can also be used with other capital property where sale proceeds are collected over a maximum five-year period.

With cottage season upon us and clients considering how to pass the cottage to the next generation, now is a great time to speak with them about potentially using this strategy. Consult a tax professional who can assist with implementation.

This should not be construed as legal, tax or accounting advice. This material has been prepared for information purposes only. The tax information provided in this document is general in nature and each client should consult with their own tax advisor or accountant. We have endeavoured to ensure the accuracy of the information provided at the time that it was written, however, should the information in this document be incorrect or incomplete or should the law or its interpretation change after the date of this document, the advice provided may be incorrect or inappropriate. There should be no expectation that the information will be updated, supplemented, or revised whether as a result of new information, changing circumstances, future events or otherwise. We are not responsible for errors contained in this document or to anyone who relies on the information contained in this document. Please consult your own legal and tax advisor.