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tax matters

It's been a dream of theirs for a long time. I'm talking about owning a cottage. Last year, Peter and Janice (my brother and sister-in-law) were surprised to find that they had inherited a cottage, located in Ireland, from a distant relative. So, last August, they flew to Ireland with the kids to stay at their new place for a two-week vacation. They were told the place had recently been refurbished.

As it turns out, what they had really inherited was a barn. Refurbished? Well, running water and electricity had been added in 2006. They thought about sleeping in the barn, but the goat would have none of that. All in all, their cottage gave rise to a pretty stressful vacation.

There are few things in the family that can cause more emotional angst than the cottage. There's no shortage of things to talk about when it comes to cottages, but today I want to focus on one idea: Owning the cottage in a trust.

The concept

It's possible to own your family cottage in a trust rather than owning it directly in your own name. The advantages? You can accomplish the following:

-Avoid probate fees at the time of death on the value of the cottage.

-Avoid a challenge under the wills variation legislation in your province.

-Protect the cottage from the attack of creditors.

-Avoid U.S. estate taxes where the property is located in the U.S. or you're a U.S. citizen or green card holder.

-Facilitate shared ownership among family members.

-Avoid capital gains taxes on death.

-Make use of the principal residence exemptions of beneficiaries.

-Enjoy use of the cottage today while providing flexibility as to the ultimate beneficiary of the cottage.

The exemption

Now, let me focus for a minute on the principal residence exemption. This is the exemption that can allow you to sell a property that you ordinarily inhabit, including the cottage, on a tax-free basis. If a trust that you establish owns your cottage, it's possible for the trust to designate the property as a principal residence and shelter the property from tax. The key is that at least one beneficiary of the trust must ordinarily inhabit the cottage. Even if a beneficiary lives at the cottage for a brief time each year this test will be met.

Now, there's a catch here. When the trust designates the cottage as a principal residence, it must specify all the beneficiaries of the trust who ordinarily inhabited the cottage. Those individuals (and their family units - that is, their spouses, common-law partners, and unmarried children under age 18) will not be able to designate another property as a principal residence for the same years that the trust designates the cottage.

Keep in mind that if a beneficiary of the trust does not ordinarily use the cottage, they can preserve use of their own principal residence exemption. All of this means that a visit to a tax pro is important before you decide to sell the cottage and have the trust designate the property as a principal residence.

In fact, it's critical when drafting the trust agreement, and placing your cottage in a trust, to get good tax advice. There can be a taxable event when you transfer the cottage to a trust (there are ways to deal with this), and care will have to be taken in who is named as a beneficiary of the trust if the hope is to use the principal residence exemption later.

Finally, the trust can designate just one property as a principal residence for any given year. As a result, problems can arise if you own more than one property in a trust. You may be unable to shelter more than one of these properties from tax. One solution in this case is to set up a separate trust for each property, although this will add complexity to your life in the form of additional tax filings and paperwork.

Tax planning can be like that. To save tax, sometimes you need to add complexity. Depending on a client's tolerance for complexity, we'll sometimes suggest doing without the tax savings.

Next week I'll finish this discussion of holding your cottage in a trust. There are some nuances and other issues to consider.