Usually at this time of year as cottage season starts to ramp up, I like to post a little reminder on social media about “What You Need To Know About Your Cottage”, linking it to the previous blog of mine from a few years ago that outlines how a cottage can be a “ticking tax time bomb”.
This year, due to the latest announcement regarding changes to the capital gains inclusion rate, I feel it is even more important to remind people who are planning to keep their cottage or vacation property in the family that there are looming tax implications. And it is now about to get more expensive. This also highlights the need to have a succession plan in place for your cherished cottage.
In April, the 2024 federal budget proposed a change to the capital gains inclusion rate, which had previously been held steady at 50% since 2001. As of June 25, 2024 for individuals, capital gains more than $250,000 annually will be subject to an increased 66.67% inclusion rate. While the capital gains up to $250,000 will continue to be subject to the existing 50% inclusion rate. For trusts and corporations, the inclusion rate on all capital gains will increase from 50% to 66.67% starting on June 25, 2024.
What does this mean for you, the cottage owner, who is planning to keep the cottage in the family forever? Well, it means your loved ones who will inherit the cottage will owe more money in taxes.
Here is how it works;
In Canada, upon death there is an Income Tax Act called a “deemed disposition rule”. It considers that just immediately prior to your death, everything you own is sold at fair market value and the difference between the sale price and the price of purchase will be the capital gains on which your estate will have to pay taxes on. Capital gains up to $250,000 will continue to be subject to the 50% inclusion rate. But now, any capital gains more than $250,000 annually, will be subject to 66.67% inclusion rate. Your primary home is excluded at this point and you can roll over your other properties to your spouse. Note that this spousal rollover only delays the “ticking tax time bomb” and the tax bill will be due eventually. Hopefully, there is enough money in the estate to cover the taxes owed. If not, those who inherited the cottage may have to take on debt, sell assets, or dip into their savings to pay off the CRA.
Here is an example of what taxes can be owed on the capital gains and how the new capital gains inclusion rate can increase that amount significantly;
Lisa and Tim have a cottage that they purchased 30 years ago for $200,000. Since then, their 3 children have grown up and they have spent their summers by the lake with their children and grandchildren. When Tim died last winter, the cottage became entirely Lisa’s. Since purchasing the cottage there has been $100,000 of renovations to the property. As it stands today, the cottage is worth $1,000,000. Lisa is currently 67 years old.
Currently, the capital gain = ($1,000,000-($200,000+$100,000)) X 50% = $350,000
Taxes owing (at Lisa’s marginal tax rate) = $350,000 x 52% = $182,000
As of June 25, 2024, this is what the capital gain will be;
New capital gain = ($1,000,000 – ($200,000 + $100,000)) of which the initial
$250,000 x 50% plus the remaining $450,000 x 66.67%
= $125,000 + $300,015
= $425,015 (this is $75,015 more than previous)
Taxing owing on the same cottage will be = $425,015 x 52% = $221,007.80,
This translates into an increase of $39,007.80.
In summary, if Lisa were to pass away the increase in the value of the cottage represents a large tax bill that her estate would have to pay and as of June 25th it will be even larger.
What is a solution for this problem?
Most families would prefer it if their loved ones inherited the cottage and not a liability because taxes will have to be paid. The easiest and most cost-efficient way of defusing the tax bomb is with life insurance. You and your family pay for the life insurance policy premiums and the death benefit from the insurance company will then assist to pay the tax bill upon your death. A permanent insurance policy can be taken out for the amount of the tax due, and that money will be available upon your death.
In Lisa’s situation, a permanent policy for $225,000 on a 67-year-old woman would cost approximately $7,700 per year. To self-fund the cottage’s tax liability, Lisa would have to save $7700 every year until she was 96 years old. With an insurance solution you can budget for the inevitable and that $225,000 death benefit would be available immediately, not years from now. At life expectancy Lisa would have paid $123,200 into a policy that would cover her $225,000 tax liability.
Planning can save you and your family money and future stress and financial burden. Maybe those who plan to inherit the cottage can help by contributing to the insurance premium because they will eventually be the ones stuck with the tax bill in the end. Contact your advisor today to discuss appropriate solutions to fit your needs.