The following tax planning strategies may help you achieve savings in the amount of capital gains tax that would otherwise be payable when you sell or transfer the ownership of your vacation home:
- Make optimum use of the principal residence exemption.
- Shift the future growth in the value of your vacation property, by:
- a direct transfer of ownership to children or grandchildren;
- transferring ownership to a trust; or
- creating a life interest and a remainder interest form of ownership.
Some of these strategies may produce actual tax savings while others are intended to achieve merely a deferral of tax.
Utilize the Principal Residence Exemption
Some people may find themselves in the situation of owning one or more properties that are worth less than what they paid for them. Therefore, capital gains tax is not a problem – at least for the time being. Or, in the case of a property that has not been held for a long time, the current market value may not be much higher than the original cost. Also, because some locations are more desirable than others, and real estate prices across Canada do not necessarily follow the same pattern of change, the appreciation in the value of a person’s house may be quite small compared to the gain on the vacation property.
The point that we are making is that you need to carefully consider how your principal residence exemption can be used in the most effective manner because one of the largest elements of the capital gains tax arising in your estate could be related to your vacation property.
Transfer the Ownership to a Child
One way of preventing a capital gain from arising on the future death of you or your spouse is to transfer the ownership now to one or more children. Such a transfer (either as a sale, or as a gift) would have the effect of shifting the ownership and the future growth in value to one or more of your children. Since children normally outlive their parents, such a move will generally have the effect of postponing the time at which there will be a deemed disposition at fair market value of the vacation property. However, as discussed earlier, a transfer of ownership at this time could give rise to an immediate taxable capital gain, because your deemed proceeds of disposition for capital gains purposes would be the current fair market value of the property.
Transfer the Ownership to a Trust
Over the past 20 to 30 years, many vacation properties were transferred into family trusts for tax and estate planning reasons. In spite of various tax changes, trusts continue to be extremely effective estate planning tools in many situations. There are several reasons for the popularity of a trust being used as a vehicle for holding the ownership of a vacation property. Many people are reluctant to transfer ownership directly to one or more children for a variety of reasons. For example, how can you know what the relationship will be like with any of your children in the future? You may not want to lose the legal control over your vacation home, as well as the legal right to use the property. A trust is a useful vehicle for dealing with some of these concerns, and for keeping the ownership of the cottage “one step removed” from the children.
Create a Life Interest and a Remainder Interest
Another planning technique which can produce results that are similar to those achieved with the use of trust, involves the creation of a life interest and a remainder interest in your cottage. If you already own a vacation property, this would mean altering the form of ownership so that one or more of your children would be granted a remainder interest in the property. You and/or your spouse would retain a life interest.
Buying Life Insurance to Cover Future Tax Liabilities
It is worth mentioning here that in many situations, the least expensive solution to the capital gains tax problem on your vacation property may be to purchase enough life insurance to cover the future capital gains tax liability. Therefore, instead of setting up a trust (and possibly paying tax on a taxable capital gain that is triggered on the transfer into the trust), it may be better to acquire some form of permanent life insurance (such as universal life or Term-to-100 insurance) to provide funds to cover the tax.
Obviously, there is a cost in taking out life insurance, and the older you are, the more expensive it is. If you are in your sixties or seventies, the premiums may be prohibitive on the amount of insurance that would fully cover the future capital gains tax liability. A further consideration is that the capital gains tax exposure on your vacation property will keep rising, if the property grows in value. Therefore, the amount of life insurance that you take out today may not be enough in five, 10 or 20 years’ time.
