Last week I started a conversation about the family cottage. I mentioned that there are generally three ways to handle your succession plan for the cottage: Give it away, sell it to family, or sell it outside the family. Last week I dealt with giving it away. Today, let's talk about selling the cottage.
Selling the cottage
I'm not suggesting that you should sell the cottage to someone outside the family - although that could very well be the simplest solution. If you sell the cottage during your lifetime, you may have cash or other liquid assets to divvy up upon your death instead of the cottage - a much easier task.
Another option is to specify in your will that the cottage is to be sold upon your death, with the proceeds added to your estate and then distributed according to your wishes. You could give family members the right of first refusal to purchase the place (either jointly, or to the highest bidder; consider letting them make that decision) after your death, before it's sold outside the family. This could cause some hard feelings if more than one child wants to buy the place but one has greater financial means to acquire it. For this reason, it's worth having a conversation with the kids today to gauge how this option might play out once you're gone.
When the cottage is sold (or gifted), either during your lifetime or upon death, there could be tax to pay if the place has appreciated in value. The principal residence exemption is the obvious way to minimize the tax on the cottage. The problem, of course, is that each family unit (you, your spouse and any unmarried children under age 18) is entitled to designate just one property as its principal residence for each year, which generally means that some tax could be owing if you own more than one property and they've both appreciated in value. Talk to a tax pro about the potential tax exposure in your case.
Managing the tax
Let's assume you're going to face some tax on the sale of the cottage because you're saving your principal residence exemption for the city home. What else can be done to reduce the tax bite on the cottage? Whether the sale takes place during your lifetime or upon death, start by making sure you've calculated the correct adjusted cost base (ACB) and keep those records handy. The higher the cost amount of your property, the less the taxable capital gain will be. Make sure you've included in your ACB the cost of all capital improvements to the cottage (whether or not you have receipts), and don't forget about any election you might have made back in 1994 to increase your ACB by using the $100,000 capital gains exemption that was available back then.
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If you're selling the cottage to family members during your lifetime, consider taking payment over a period as long as five years. By doing this, you'll be able to spread your tax liability out over a five year period thanks to a deduction in our tax law called the "capital gains reserve."
In fact, if your intention is to give - not sell - the cottage to family members during your lifetime, consider selling the property to the family at fair market value, but take back five promissory notes for the price rather than cash. The notes can become due upon demand starting on January 1st in each of the following five years. This will allow you to spread your tax liability over a five year period (the maximum deferral allowed). You don't need to actually collect on these promissory notes. You can simply leave them outstanding and forgive them upon your death. There is no tax consequence to forgiving these notes upon death.
The effect of this strategy is the same as a gift to the family, but you will have spread your tax bill over five years. The alternative is to make an outright gift and pay all the tax in the year the gift is made. Make sure you visit a tax pro for proper drafting of the promissory notes. If you get this wrong, you may not be entitled to the capital gains reserve.
Finally, never sell the cottage to family for less than fair market value. If you do, you'll still pay tax as though you collected full market value, but your family will have an ACB of the lower amount they actually paid. The result? Double tax on the difference between those amounts. Ugh.