The kids will inherit the cottage, but who will pay the capital gains?

With the exception of a house, a cottage is the most significant investment people make, both in terms of money and emotion. Most people don't plan to leave a car or a stock portfolio to the next generation, but the cottage is another story. Whether it's a rustic cabin with hand-me-down furniture or a second home with all the amenities, it's the family memories attached to a cottage that make it special.

Sue Howard loves having her mother's cottage in Leville, NS. Since Howard's siblings had no interest in owning the small, rustic property, Howard's mother set up a will giving Howard the cottage as part of her inheritance. "She asked the lawyer if she had to sell the property at full value," says Howard. "He said it was her property, she could sell it for as little or as much as she wanted."

Howard's mother died in 2002 and the estate sold Howard the cottage for $1; the actual value of the property was taken out of her share of the inheritance. "I don't know what others might think of this, but it worked well for us," says Howard. "I now have a darling little cottage that we've gutted and are in the process of renovating, which, when we finish, will be worth a heck of a lot more than I 'paid' for it!"

Unfortunately, things can often be much more complicated when it comes to family cottages. According to a Royal LePage Real Estate Services survey, 97 per cent of recreational property owners say they share their vacation home with family and 81 per cent plan to pass that property along. Take Jean Fry, for example. Fry's mother bought a cottage in Nova Scotia in 1963. When she died, she left the property to Fry and her brother and their respective spouses. Since then, the brother's half of the cottage has passed to the next generation. Now Fry and her husband are considering what to do with their half. "We plan to pass it on to our son when both of us die," says Fry, but she doesn't know how she's going to do that. It will mean the two cousins, who live in different provinces, will have to work out how to own the property together. It also means the Frys or their son may have to take a financial hit.

"People tend to hold onto their cottage until they die," says real estate lawyer Erin O'Brien Edmonds, but if they choose to transfer the property through a will, people should be aware of the implications. Not only are the inheritors left to work out often-complicated co-ownership plans, but transferring a cottage on death triggers capital gains taxes, and someone has to pay that large tax bill.

Capital gains taxes are 50 per cent of the difference between the value of the property when it was bought and when it was sold. If you bought a cottage in 2000 for $100,000 and sold it in 2010 for $300,000 (hypothetically, of course), you will have recognized a gain of $200,000. Half of that, or $100,000, is taxable as income.

If you have a small rustic property like Sue Howard's, whose whole cottage measures 16' x 24', capital gains may not be a big issue (when Howard sells, the bill to the feds will be calculated using the assessed value of the property, not $1). However, location and any number of other factors can mean the sale value will be drastically higher than the purchase price.

"People can get in these situations where the tax bill is so huge that the only way to pay it is to sell the cottage," says Douglas Hunter, Port McNicoll, Ont.-based author of The Cottage Ownership Guide. He says that some people either don't know about, or choose to ignore, the tax implications, but says that can be a risky gamble. When he was promoting his book, Hunter met one man who said he just gave the cottage to his daughter more than a decade ago. "So this guy or his daughter was really facing 12 years of interest and penalties, plus the unpaid capital gains tax, and he thought that was just fine." Hunter says people who care enough to leave a cottage to family need to do some planning to minimize the impact on the next generation. There are no perfect solutions and there isn't a way to get around all the taxes, but there are a number of options, depending on your particular circumstances and the value of your property.

Reducing the capital gain

The first step in preparing for a transfer is to reduce the amount of taxable gain. Keep track of all the capital improvements you've made to the cottage since purchase. When it comes time to calculate the capital gains tax, those figures will increase the original assessment value, which will decrease the amount of capital gain. Allowable improvements include a new deck or landscaping, not general upkeep.

Life insurance

A policy taken out on the property owner but paid for by the kids can reduce the cost burden at the time of death. Life insurance broker Graham Young, based in Dartmouth, NS, says having the children pay the premiums means they can get the cottage for a lot less than just paying the taxes upfront, since the policy payout covers most of the capital gains. Young says if you start a policy for parents in their 50s or 60s, "you're probably covering the taxes for 10, 20 maybe 25 cents on the dollar."

Deeming the cottage a primary residence

With the rising value of vacation properties, owners are increasingly likely to find their cottage is worth more than their home. Changing your primary residence will trigger the capital gains tax, but when the cottage goes to the kids, there will be no additional taxes.

Gifting

Giving the cottage to your kids before you die will trigger the capital gains tax based on fair market value (FMV), even if no money changes hands. If major gains in value are expected in the future, gifting the cottage now can be advantageous in that the tax based on today's FMV will be significantly lower than the tax based on future value.

Trusts

Trusts are a legal entity wherein a property is transferred to one or more people. Trustees manage the property on behalf of the beneficiaries. In this context, a trust can offer a measure of control, as well as define the terms of joint usage. Depending on the type of trust, the capital gains tax will likely be paid when the property is put in trust. Trusts can get complicated and be expensive to establish, but they can be a good option if multiple owners are paying for maintenance and improvements. Capital gains tax is triggered every 21 years in a trust.

Joint tenancy with rights of survivorship

In this case, two people own the property equally; when one member of the joint tenancy dies, the whole property reverts to the surviving owner. Half of the capital gains tax has to be paid when the joint tenancy is set up. The other half is due when the parent dies, and the property automatically reverts to the child.

Every situation is different, and some people may find it useful to talk to an accountant or financial advisor. With properties worth hundreds of thousands of dollars, Hunter says the cost of a few hours of professional advice should pale in comparison. "The downside risk is facing literally tens of thousands of dollars in unhappy tax experiences, either to themselves or their offspring."

The most important conversation, however, is the one with the kids. "Everybody needs to be on the same page," says Hunter. "It's surprising the number of times the parents will make assumptions about what the kids want and what they should do with the cottage, when really the kids don't want that."

Keeping the family peace

If you have more than one child, deciding who gets the cottage is rarely easy. Many parents choose not to favour one child over another and, instead, leave it jointly to all the kids. It's a solution that, while seemingly easy upfront, is usually problematic. There are questions of schedules and paying the taxes and upkeep. The personal life of one sibling can also be a problem for the others if di-vorces or credit problems become an issue.

Jane Jackson owns a cottage on Melmerby Beach in Nova Scotia with her mother and two siblings. They've set it up so when one dies, ownership automatically passes to the surviving owners. Jackson says that works well for some things but it still leaves unresolved problems. "Things like doing any major renovations," she says. "We have been talking about it for probably five years and have not done any of it because we haven't been able to agree. I think that's fairly common for a lot of people in our situation."

In fact, 22 per cent of cottage owners expect feuding if they leave the property to family, and 11 per cent say the cottage has already caused a family rift. "These things are all really tricky," says Dartmouth, NS-based real estate lawyer Erin O'Brien-Edmunds. "They only work if you have hyper-planning. You really have to put it in writing."

Douglas Hunter, author of The Cottage Ownership Guide, says the best way to prevent problems is to be honest upfront. He says parents know their kids and have to be realistic about what to expect. "You're not going to be alive to help them," says Hunter. "There is no co-ownership agreement in the world that's going to work if they just can't get along.