Untangling cottage tax issues

The family cottage — or cabin, chalet, or camp depending on where you are in Canada — is a place of glorious summer days, treasured family memories, and some of the most difficult tax and inheritance issues that a family ever ends up managing.

The combination of emotional connection, market appreciation, and the increasing ubiquity of blended families makes these properties into a snake pit of tax and estate issues. Untangling these issues takes proactive work and family consensus, areas where Christine Van Cauwenberghe believes advisors can demonstrate their value. The head of financial planning at IG Wealth Management says that by facilitating frank and open conversations about the tax and estate implications of a recreational property, advisors can get their clients ahead of any emerging tax issues.

“A lot of people don’t really think about the tax issues, they just think that they want the cottage,” Van Cauwenberghe says. “The biggest issue for a lot of people who have a cottage is about how they pass it on and who they pass it to. That’s when they go talk to a professional and realize there’s likely going to be a capital gain. They can’t pass it on to a family member without a tax bill, and that comes as a surprise to some people.”

Family cottages are often a blind spot for clients because they may have inherited them years ago, when there either wasn’t a capital gain on the property or when the $100,000 lifetime capital gains exemption applied. The rapid growth of recreational property values in recent years, however, has made capital gains far more common on these properties. It can also surprise people because passing the property on to a spouse can be done on a tax deferred basis but passing it to the next generation generates a capital gain.

As advisors begin to talk to their clients about the tax and estate implications of a cottage property, Van Cauwenberghe says that they should begin by asking what the whole family plans for the property. Most parents don’t want to treat their children differently, and think they can simply leave the property to all their children. The trouble is, not every child will be in the same economic circumstances, and not every child will even want the property. That’s before we get into the issues of blended families. Sharing arrangements often break down in ugly ways.

Van Cauwenberghe says it’s best to address these plans with the whole family, with parents asking their children who wants this property, with all the tax, maintenance, and cost implications that comes with it. Sometimes the next generation will simply decide to sell the property and divide the proceeds. Sometimes one child really wants the property, and the other children will need to be paid out.

“Just assuming it will all work out and they’ll be sitting around the fireplace singing kumbaya, that’s generally not realistic,” Van Cauwenberghe says.

Some retired individuals may move to the cottage, turning that house into their principal residence and selling their old home in the city. Van Cauwenberghe says that’s only a partial solution. Selling the old principal residence consumes the exemption for the years an individual lived there. Any gains that occurred on the cottage in the years when it was a recreational property still apply.

The growing complexity of recreational properties is somewhat a reflection of how complex Canadian life has become. As with so many aspects of residential real estate, cottage prices have risen dramatically — especially during the pandemic, though there has been some pullback more recently. Blended families are more common, as are more widely dispersed families. The tax regime has become more complex as well, with a higher inclusion rate for capital gains over the $250,000 personal exemption.

“You’ve got a perfect storm of issues that can arise on what are usually very emotional properties,” Van Cauwenberghe says. “Most people are totally fine to sell mum and dad’s house, but deciding to sell the vacation property can be much more difficult.”

There are some areas of hope, however. Many cottage owners have significantly upgraded their properties in recent years. Advisors need to ask if records were kept on renovations and improvements, because those could significantly reduce the amount of capital gains.

As they look for solutions, Van Cauwenberghe says that advisors need to host a family meeting to determine what everyone’s intention is. A frank discussion can help manage any assumptions that family members may have about a cottage. The parents may learn their kids don’t want to keep it, or the kids may learn how much it costs to run, from maintenance costs to sky-high property tax rates. Dispelling any delusions and explicitly stating goals can go a long way to manage the snarl of issues that could emerge from a cottage.

“We recommend that advisors talk with their clients about their general estate plan every few years, that could be about the legacy they want to leave, charitable giving, and bigger picture issues, but that’s also the point where you would take an inventory of their assets,” Van Cauwenberghe says. “This same discussion can come up with rental properties and businesses, which can be surprisingly emotional for people. But have that general discussion, ask what they own, who their intended beneficiaries are, and that their expectations are. If they have a plan that’s great, but if they don’t then it’s an opportunity to involve the family in a discussion.”