Cottage memories are like none other.
If you're visiting a friend's cottage this summer, here are a few tips that will be sure to create lasting memories for everyone: Bring four very large suitcases (store one in each bedroom if necessary), bring at least two dogs (those with digestive problems are best), start a fire (preferably outside the cottage, and big enough to burn a picnic table), roast marshmallows (bring those mini ones with toothpicks and see who can stand the heat) and scare the kids (ghost stories to give them nightmares for three days can add to the fun).
All kidding aside, great memories at the cottage can continue for generations – with good planning.
My past two articles in this space dealt with the issue of who in the family, if anyone, would be best suited to inherit the cottage, and whether or not a transfer should take place during your lifetime, or upon death. The fact is, a transfer of the cottage – whether as a gift or sale, and whether during your lifetime or after, could trigger a tax hit if the property has appreciated in value. Today, I want to talk about steps you can take to reduce the tax bill on the eventual transfer of the cottage. Consider the following ideas:
1. Use the principal residence exemption.
A gift or sale of the cottage will be treated as a disposition at fair market value. It may be possible to use your principal residence exemption (PRE) to shelter a gain from tax, whether during your lifetime or upon death. The PRE can only be used to fully shelter one property from tax if you own more than one at the same time. Be sure to visit a tax pro to determine whether you're able, and whether it makes sense, to use the PRE on the cottage.
2. Maximize your adjusted cost base.
Keep track of all major repairs and improvements to your cottage over the years. You may be able to use these amounts to increase your adjusted cost base (ACB) of the property. A higher ACB will mean a lower capital gain, and lower taxes on the transfer of the cottage.
3. Leave it to your spouse.
If your plan is to transfer or sell the cottage after your death, consider leaving the property to your surviving spouse. This can defer the tax, if any, until the date of your spouse's death.
4. Make a transfer today.
If you want to make a transfer during your lifetime, consider doing it today. This will move the future growth – and future tax bill on that growth – into the hands of your heirs, deferring the tax for years. You'll still be deemed to have sold the property at fair market value today when making the transfer, but there might be little tax to pay if the property hasn't appreciated much. You can maintain control and use of the property even after a transfer using a trust or an agreement with your heirs.
5. Claim a capital gains reserve.
If you want to gift the cottage to your kids during your lifetime, try this idea: Rather than gifting the property, sell it to the kids at fair market value and have them pay you using promissory notes. You don't have to collect on the notes if your intention is to make this a gift; rather, you can forgive the notes upon death without tax implications. If you structure the notes properly, the tax on the "sale" can be paid over a five-year period of time rather than all in one year, using what's known as the "capital gains reserve." If you simply make a gift, and taxes are owing, you'll have to pay that entire tax bill in the year of the gift.
6. Claim capital losses to offset a gain.
If you have other assets, perhaps investments, that have dropped in value, consider selling those assets to realize the capital losses. These losses can be applied to offset any taxable capital gain on the transfer of the cottage.
7. Buy life insurance to cover the taxes.
While this idea won't eliminate the tax bill upon death, it can provide needed cash to pay those taxes where the plan is to keep the cottage in the family and not sell it after you're gone. You might also consider buying enough insurance to help fund all or part of the annual maintenance costs for your heirs. Life insurance may allow you to fund the tax bill using just pennies on the dollar.
Tim Cestnick is president of WaterStreet Family Offices and the author of several tax and personal finance books.