Have a cottage? Make a plan to keep it in the family and transfer the property to the next generation

Watching water lapping against the dock as the sun sets over the lake. Pouring a round of lemonade for laughing children on a hot summer afternoon. Sipping coffee on a deck surrounded by chirping birds and rustling tree branches. Cottages are the setting for so many magical moments. That’s why it’s critical to make a plan to      transfer the property to the next generation – so your children and grandchildren can keep the cottage in the family and continue making exquisite memories.

Many people assume that simply leaving the cottage to adult children in a will ensures they’ll get to keep it. The trouble is that a second property like a cottage is taxed on death as if you had sold it. If your cottage has increased in value since you bought it, that could mean a huge capital gains tax bill. And, of course, the longer you’ve owned (and continue to own) your cottage, the more time it’s had (and continues to have) to increase in value.

Maybe your estate will have sufficient assets to pay the tax – though this may mean selling investments when markets aren’t at their best. If not, the inheritors will have to pay the tax themselves. If there aren’t enough liquid assets available from the estate and/or from them, they may be forced to sell the cottage to pay the tax. That’s likely not the result you want.

The good news is that putting straightforward strategies in place can help you manage the tax bill so your family can enjoy your cottage for generations to come.

Here are four ways to keep the cottage in your family:

1. Make adult children joint owners
2. Set up a personal trust
3. Buy permanent life insurance
4. Designate the cottage as your principal residence

Strategy 1: joint ownership

Making adult children joint owners of the cottage allows you to deal with the capital gain now, before it gets any bigger, and then have a tax-free transfer on death.

The legal structure is called “joint tenants with right of survivorship.” It makes children joint owners during your lifetime and, when any owner dies, the title to the cottage transfers directly to the survivors. You will have to pay tax on the portion of ownership that transfers – but, when structured appropriately, the other owners won’t have to pay tax on your death. In addition, the cottage won’t form part of your estate, which means it won’t be subject to probate fees (where applicable).

It’s important to consider whether you’re comfortable giving up full ownership of the property, and to discuss with family members how decisions regarding the property will be made going forward – including decisions to repair, renovate or sell.

Strategy 2: personal trust

An inter-vivos trust, set up during your lifetime, keeps the management and control of the cottage in your hands, while the trust owns the cottage.

You’ll pay tax on capital gains up to the point the cottage transfers into the trust. However, future capital gains will be sheltered from tax for 21 years. There will be a deemed disposition of the cottage then (with any tax due), and every 21 years after that. As with joint ownership, assets in a trust aren’t considered part of your estate or subject to probate fees.

There are costs associated with setting up and maintaining a trust, but there’s also lots of room for customization and you can leave instructions related to the cottage that continue beyond your lifetime.

Strategy 3: life insurance

Instead of reducing capital gains tax, you can buy permanent life insurance to cover it. With a “joint last-to-die” policy, the death benefit goes tax-free to beneficiaries when the second parent dies – exactly when money is needed to pay the tax.

It’s up to you whether you aim to match the projected tax as precisely as possible, or get additional coverage to cover other taxes and costs due on death. Some permanent life insurance policies even provide an opportunity for the death benefit to grow over time.

One challenge is that it gets more expensive to buy life insurance as you get older. You may want to ask adult children to pay the premiums, since they’ll ultimately benefit from the policy.

Strategy 4: principal residence

Let’s say you have a condo in the city and a cottage in the country, and the cottage is rising in value at a much faster pace than the condo. You may be able to designate the cottage as your “principal residence” so it benefits from the principal residence exemption from capital gains tax when sold or when you die.

To be claimed as a principal residence, a property must generally be “ordinarily inhabited” by the taxpayer, his or her spouse/partner, former spouse/partner or child, and the Canada Revenue Agency has other rules as well. Also, you will have to pay tax up to the point the cottage becomes your principal residence.

That said, based on your specific situation, this can be an effective way to eliminate taxes due on the cottage on death – and you can use one of the other strategies to manage taxes due on your condo.

Skip stones, not planning

Overall, cottage owners should think carefully about their wishes for the property. They should keep receipts for all repair and renovation expenses, which can reduce the capital gain on a cottage. And they should work with an advisor to build the cottage into their estate plan.

Do all of this to give children and grandchildren more than memories. With appropriate planning, they can keep enjoying wonderful times at your cottage well into the future.