It is officially, cottage season. With the May long weekend upon us, cottage expenses and finances are on people’s minds again. The cottage is a big part of many people’s childhoods and acts a central hub for families to gather, relax and grow. If the intention is to keep the cottage in the family forever, a looming issue needs to be addressed immediately. Most people do not know that their cottage is a ticking tax time bomb.
What is a Tax Time Bomb?
Death and taxes are the two of the few guarantees we have in life. Unfortunately for cottage owners, there will be a capital gains tax due even after your death. 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. Your primary home is excluded at this point and you can roll over your other properties to your spouse. This spousal roll over only delays the “ticking tax time bomb”, 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 must take on debt, sell assets, or dip into their savings to pay off the CRA. Most families would prefer if their loved ones inherited the cottage and not a liability, but the tax time bomb may not make that possible. Here is an example of the tax time bomb that a cottage can present:
Jessica and Matt have a cottage that they purchased 30 years ago for $200,000. Since then, their 3 children have grown up and Jessica and Matt have spent their summers by the lake with their children and grandchildren. When Matt died last winter, the cottage became entirely Jessica’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.
Capital gain = ($1,000,000-($200,000+$100,000)) X 50% = $350,000
Taxes owing on the capital gains will be at Jessica’s marginal tax rate. Taxes owing on the cottage = $350,000 x 52% = $182,000
$182,000 will be the amount of tax due on the cottage upon Jessica’s death. Jessica is 67 years old, if Jessica were to pass away today this large increase in value represents a large tax bill that her estate would have to pay. If the cash is not there the family cottage may have to be sold to make up the difference.
What is the solution?
The easiest and most cost-efficient way of defusing the tax bomb is with life insurance. You and your family pay for the policy premiums and the insurance company will then 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 Jessica’s situation, a permanent policy for $200,000 on a 67-year-old woman would cost approximately $6,600 per year. To self fund the cottage’s tax liability, Jessica would have to save about $6,600 every year for 30 years. With an insurance solution you can budget for the inevitable.
It is a great time to have a conversation with your kids about the cottage. Are they aware of the tax bill they will be inheriting? Planning ahead can save you and your family money and future stress and financial burden. Maybe they can help by contributing to the insurance premium because they will eventually be the ones stuck with the tax bill in the end.
Photo by April Barber on Unsplash