FidelityConnects: Cottage planning – Estate and tax strategies

[00:03:39] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. It is autumn, the leaves are changing to brilliant colours, outdoor barbecues are getting wrapped up for the winter, and those lucky enough to own a family cottage or a lake house or a ski chalet maybe, the pipes, of course, will need winterizing and the windows boarded up. It is the land of real estate investing and where, ultimately, does cottage ownership fit within this discussion? Is it an investment, is it a cost season after season, and how to divide such assets between children when a parent dies or when a parent would like to sell out of their interest? There are several tax-efficient manners in which to attempt such a thing, and there are also a host of tax-inefficient ways to pass on the family heirloom. Joining us here today to discuss the tax structures that really matter when attempting to change the deed on a family cottage is Director of Tax and Retirement Research, Jacqueline Power. Warm welcome to you, Jacqueline, great to see you.

[00:04:38] Jacqueline Power: Thanks so much.

[00:04:38] Pamela Ritchie: Thanks for joining us here today for this exciting topic and for the next 30 minutes or so you can certainly write into Jacqueline, use the question option there and we'll pass them on to her to answer some of your questions. This type of year does kind of bring up a lot of feelings about closing things up for the winter. Actually, is it a time when cottages get sold? Is this a time when things change?

[00:05:02] Jacqueline Power: Great question. To be honest, I think I see more cottages going up for sale in the spring, people are wanting to have the season. There are, of course, some that will be sold at this time of year but I think why it's so important at this time of year is because people are closing the cottage, they're realizing this might be our last season. This is, essentially, giving them the winter to think about, okay, how are we going to transition this? Who wants the cottage and what do we want as far as that transition is concerned? I think that's where it comes in.

[00:05:37] Pamela Ritchie: It's a really interesting part of the retirement planning piece because from what I've heard over the years you don't want to get to an age where actually it's really too much because it's quite a lot of work and it could be treacherous if you get to an age when you don't want to do it. How does it fit into the retirement pie as you divvy things up and talk about things?

[00:05:56] Jacqueline Power: I always encourage the conversation as early as possible because they don't want to be in a situation where now you're being forced to do this transition and you're doing it under stress. It's really interesting because different people have different ideas as far as when they want to transition it. Some want to do it during their lifetime so it's not an asset in their estate upon their passing. It can make it smoother sometimes if it's done during their lifetime so we are seeing that that is happening more and more. For the individuals who are wanting to transition in their estate they need to make sure that they're really planning for that. Because of the fact that all of our assets are deemed disposed right as we pass away it's so important to make sure that there's enough money in the estate to be able to cover the taxes, not just on the cottage but on everything.

[00:06:46] When we look at some of these cottages in Muskoka, they probably have at least a million dollars in gains on some of these cottages so that's going to be taxable within the estate and they need to make sure that they have enough money within the estate to cover that. We've seen lots of situations where the plan was for the family to keep the cottage the next generation but because of all the tax within the estate they had to sell the property. 

[00:07:14] Pamela Ritchie: So all the taxes but also just sort of the unknown cost. You get up there and you think, great, you've got the basket of things you need to eat for the weekend and whatever laundry you need to do and so on but there are serious costs associated with running a cottage, just like a home.

[00:07:28] Jacqueline Power: Very much so.

[00:07:30] Pamela Ritchie: What do you recommend on just getting grips on that?

[00:07:35] Jacqueline Power: I do this type of presentation a lot and after I did one of the sessions I was approached by a woman who had the most brilliant idea and I've been telling it to everybody that will listen to me. Essentially, what she and her husband are doing this year is at the beginning of the year when they opened the cottage they just got a log out and started making notes of absolutely everything. They're like, we opened the college on this date, it took us this many hours to open the cottage. Then she would move on to, okay, frequently, I remember from my childhood cottage, there were leaks in the water system so you have to fix the leaks. If you can do that yourself how much time does that take? If you have to hire somebody what's that cost? Essentially, what she and her husband are doing is they did this for the entire summer. Every single weekend if they cleared brush, how many hours did it take them to clear that brush? If a new roof had to be put on the cottage what was the cost associated with that? What's the insurance associated with it? All of these costs she is just keeping track of throughout the entire year.

[00:08:35] What her plan is at the end of the season, she's going to sit down with the children and say, okay, we worked on the cottage for x amount of hours, we spent x amount of dollars throughout the season, is this something that you're willing and able to take on. I think that's the best way to do it. I think all of us want the cottage, I mean, I know my brother and I very much wanted the family cottage but we had no idea the cost and the work that was involved in that. Even though we went up to the cottage most weekends and stuff my parents were the ones who did everything so we really had no concept of that. I think that's very common with a lot of children.

[00:09:14] Pamela Ritchie: Once you get to that point where you sort of get a clear picture of what needs to be done then I guess the question of divvying up ... there could be several siblings, for instance, of who's going to do it and pay for it, and can afford to pay for it.

[00:09:27] Jacqueline Power: That's the thing too. Also, it's who's going to use it and when. These are all conversations that need to be had.

[00:09:35] Pamela Ritchie: So they may not all stay together.

[00:09:37] Jacqueline Power: Exactly, and most of the time you don't want to. If you have families and everybody has their own children and that sort of thing the cottage may not be able to have everybody in at the same time. We generally have about nine good weeks of summer so if you have three children then how theoretically each child will get the cottage for three weeks, but then how is it determined what weeks they have the cottage. August long weekend, the week after that is a pretty sought after week for vacation so does one person always get that week, does that week rotate, how does that work? These are all conversations that need to be had beforehand.

[00:10:16] Same thing you mentioned the maintenance, this was the issues that arose with respect to my brother and I. We're originally from Ottawa, the cottage is about an hour and a half from Ottawa, in Quebec, and I live in Toronto so it's six hours for me to get to the cottage. It was an hour and a half for him to get up there. He would go up to the cottage every weekend, treat the cottage like it was his own but what I was finding was he wasn't doing the maintenance, he wasn't cleaning up after himself so would go out there and, essentially, have to do all of this myself. I was going up for two separate weeks every summer and working the entire time. It was creating massive friction between my brother and I. My parents never thought that we would need a co-ownership agreement or something like that because of the fact that we were best friends going into this. We'd also been going to that cottage for decades so we knew how the cottage needed to be left. Essentially, I think my brother and his family felt this was their cottage and that they could treat it as they wanted. That created massive, massive problems between us.

[00:11:24] Pamela Ritchie: Ultimately, what are the different ways ... if the siblings were to decide, okay, this is, in fact, what we want, we've considered it for a little bit and we know we're going to have to divvy this stuff up, how does the actual transfer take place? It sounds like the parents could just sell out of it and sell it to their children, basically, that's one option, and then they just sort of say, okay. It's yours now and that's the end. Why is that inefficient?

[00:11:53] Jacqueline Power: If they're selling it outright essentially what happens is they're paying capital gains tax based on what the fair market value is. The difference between the adjusted cost base and that fair market value, that's what's going to be taxable to them. Depending on the situation that can be a massive gain that somebody has in one year. We find that that is a frequent occurrence a lot of the time.

[00:12:19] Pamela Ritchie: Why would people take that route? It does sound kind of clean and simple, and expensive.

[00:12:24] Jacqueline Power:  I think that's exactly the reason why, it's done. All of a sudden, yes, they're paying this large capital gain but now it's done and they don't have to worry about it. Kids are the ones who are now responsible for it. If you're looking at parents who are 80 years old, to your earlier point, they may not be able to physically do some of that stuff so for them to take this hit as far as that capital gain is concerned, it's worth it to them because it's freeing up time for them and they know that now the children are the ones who are going to be taking care of it going forward.

[00:12:57] Pamela Ritchie: That is one option of how you would get there to that end, what are some of the others? What are other ways of looking at this? Could you sell it to them for less because it's your kids and you think, well, you know, you don't have to pay the full amount, like, I want you to have it, just pay half or less or whatever.

[00:13:13] Jacqueline Power: Exactly. And that, people don't realize, can actually put the cottage into a situation where double taxation arises. What happens is the parents are still having to pay capital gains tax based on what the fair market value of the property is.

[00:13:27] Pamela Ritchie: If the property is worth a million dollars or, let's say, $800,000 that's what they're paying taxes on anyway.

[00:13:33] Jacqueline Power: Exactly.

[00:13:33] Pamela Ritchie: Even though they're selling it for, say, $400,000.

[00:13:35] Jacqueline Power: Exactly, and then what happens is because the children are only paying $400,000 for it in that situation their ACB is $400.000. That's where we're coming into that situation where double taxation can arise.

[00:13:50] Pamela Ritchie: Do people do that, though, anyway?

[00:13:52] Jacqueline Power: I think some do but it's not advisable. In that situation I would say it would make more sense to gift the cottage to them, then you're not collecting the proceeds of sale. I get that 400,000 not collecting, that is a lot so you do have to weigh what makes more sense in your particular situation but by gifting it, essentially, the child's ACB is going to be what the fair market value was.

[00:14:19] Pamela Ritchie: When they go on to sell it that's where they will get hit--

[00:14:22] Jacqueline Power: Exactly.

[00:14:23] Pamela Ritchie: --with the capital gains at some point. But the gifting process is, as it sounds, you are gifting, you're giving it to them.

[00:14:29] Jacqueline Power: Exactly, exactly. So you give it to them, you pay tax based on difference between fair market value and ACB and then child's ACB is what that fair market value was.

[00:14:39] Pamela Ritchie: So, essentially, the kids are being given a cottage that is worth exactly what the market says it is.

[00:14:45] Jacqueline Power: Exactly, and you have to do appraisals and that sort of thing. Those MPACs that we get, the government's not okay with that. They know that those are underestimated values of the property so they are going to ask for an actual appraisal to be done.

[00:15:01] Pamela Ritchie: By a real estate person or someone.

[00:15:04] Jacqueline Power: Exactly.

[00:15:04] Pamela Ritchie: Now, there is another way of taking a look at this and it goes into the realm of capital gains reserves. How does this work? I think you think this is one of the best so tell us why. How does this work?

[00:15:14] Jacqueline Power: The idea behind it is there's a section in the Income Tax Act that states that if you're not collecting all of the proceeds of sale all at once that you're able to spread that gain over a maximum of five years. Now, whatever proceeds of sale are being collected in a particular year the gain that applies to that would have to be realized in that year.

[00:15:34] Pamela Ritchie: Let's say if it's $800,000 in total you do sort of over the course of up to five years, just say four years, $200,000 per year if it's four years?

[00:15:42] Jacqueline Power: Exactly, exactly. It ends up working quite well because instead of having .... so just for easy math I go with 500,000. If we're looking at a $500,000 gain when you sell the property, if you sell it just outright you're realizing that gain all in one year. If, instead, you choose to do a virtual sale to the next generation, you could sell it to them using a promissory note or using a demand loan, that's when you can use the capital gains reserve because what's happening is you're not actually collecting any proceeds of sale because it's a virtual sale that you're doing. Instead of having to realize the $500,000 gain all in one year you can evenly split $100,000 over five consecutive years. It just ends up being better from a tax perspective. In the end CRA still gets their $500,000 in tax but, hopefully, by having a $100,000 gain it can keep them in a lower tax bracket, rather than if you have a $500,000 gain chances are you could be pushed into a higher tax bracket.

[00:16:46] Pamela Ritchie: Who owns the cottage in that situation?

[00:16:48] Jacqueline Power: At that point it would be the children because that virtual sale has been done. There's a sale agreement that has happened so now the children would own that cottage rather than the parents. That's how they're able to lock in that price at that particular ... that's how we're locking in the gain because the sale has actually happened. With this strategy we find it generally works best when we're selling to family members. Generally, they wouldn't want to sell it to a third party because then there's more risk involved when you're selling it to somebody who isn't in the family.

[00:17:19] Pamela Ritchie: What's going to happen five years down the road.

[00:17:21] Jacqueline Power: Exactly. Are they going to continue to make the payments that they should be making, that sort of thing.

[00:17:28] Pamela Ritchie: When you go through all of these different scenarios what do you find actually people are most interested in?

[00:17:36] Jacqueline Power: I find, funny enough, most of the sales are being done either as a gift or fair market value sales. Very few, to my knowledge, are actually taking advantage of the capital gains reserve.

[00:17:50] Pamela Ritchie: Why is that? I mean, it sounds like a good option.

[00:17:53] Jacqueline Power: It's a great option. I think it's a matter of education, I think a lot of individuals are not aware of it.

[00:17:59] Pamela Ritchie: They have a marketing problem.

[00:18:00] Jacqueline Power: Exactly, exactly. We can help them.

[00:18:04] Pamela Ritchie: We can help them, you're helping them right here.

[00:18:08] Jacqueline Power: I think it's just a matter of getting the word out. In most circumstances whether you're looking to gift it, whether you're looking to sell it this is an excellent way to get it into the next generation's hands.

[00:18:21] Pamela Ritchie: From the government's perspective, they want to make sure that their tax dollars come in at some point, are they also trying to allow for options to make sure things can pass down to the next generation, or at the end of the day is the goal just the money, or are they trying to provide some options?

[00:18:37] Jacqueline Power: I can't get in their heads, I don't know exactly what they're thinking. I mean, in my opinion, CRA always eventually wants their tax dollars, right? Whether they allow us to defer getting that to them eventually they are going to want their tax dollars. They throw us a bone with some of these strategies but eventually they'll get their dollars.

[00:18:58] Pamela Ritchie: Are there other structures in which to own property? People will own property in trusts, there are different ways to sort of put structure around things that have a more seamless transition. Why would that be more useful than, for instance, the capital gains reserve?

[00:19:15] Jacqueline Power: That's a great point because it is different from a tax perspective. You're not able to use the capital gains reserve if the property is going into a trust. Now, there are lots of benefits to putting a property in a trust. First, just from a task perspective, at the time that the property goes into the trust it is a taxable event so that would be taxable to the settler, to the individual who put that into the trust, and they would have to pay whatever the applicable capital gain would be. Now, the benefit is now the trust owns it. When we're looking at estate planning, for instance, that cottage is no longer something that you have to worry about in the estate because it's not flowing through the estate anymore because of the fact that the trust owns it. It wouldn't be subject to probate because, again, the trust owns it rather than the individual themselves.

[00:20:06] Where it can also be really beneficial is when you're looking at the beneficiaries who are inheriting it. I'm not trying to be a negative Nellie by any means but we have a high divorce rate in Canada. If those individuals own the cottage outright at the time of the divorce their portion of the cottage would be considered property when equalization calculations are being done and that sort of thing. If the trust owns it rather than the individual themselves that's not an issue. Another thing is if beneficiaries have creditors. If they owned the cottage individually the creditors could seize their portion of the college, whereas by having that in the trust it can be beneficial from that perspective.

[00:20:50] Pamela Ritchie: So, so interesting. You have so many questions coming in so let's go through to some of these. This actually goes to the principal residence, not the cottage, what is the best way to pass on a principal residence to a grandchild? So skipping a generation.

[00:21:08] Jacqueline Power: With a principal residence, essentially, if somebody declares the principal residence exemption on their principal residence then there's no tax that would apply in that situation, and then in their will they could just indicate that the grandchild is the one who is going to be inheriting that. That's no problem whatsoever.

[00:21:28] Pamela Ritchie: Is that like gifting in terms of how the grandchild receives it.

[00:21:33] Jacqueline Power: Exactly, they would receive it at fair market value. That would be their ACB. Now, on this sort of vein as far as the principal residence is concerned, I think a lot of Canadians don't realize we can actually use our principal residence exemption either on the home in the city or on the cottage.

[00:21:52] Pamela Ritchie: Not both, though, obviously.

[00:21:54] Jacqueline Power: Exactly. Now, funny enough, we were able to use both at one point if you had a spouse. Right now as of '82 onwards, as a family unit you need to decide which property you're designating as the principal residence, but prior to '82 each spouse had their own principal residence exemption.

[00:22:12] Pamela Ritchie: So one could be the cottage.

[00:22:14] Jacqueline Power: And one could the house in the city. What's even more interesting is prior to '72 we didn't have any capital gains at all. Essentially, December 31, 1971, that was V-Day so that's when you would have valued your property and that would be your ACB at that point and then it would just be any gains after from '72 onwards that would be taxable.

[00:22:37] Pamela Ritchie: So there's been some time in between there, that is no longer something new. That's really, really interesting. You've gone at this a couple of different ways but let me just read this question. If you donate the cottage to your children while alive, and capital gains are substantial, you might get hit by the AMT tax. What are your recommendations? You've answered a little bit but let's go back to it.

[00:23:00] Jacqueline Power: As far as AMT is concerned I would highly recommend that they do a pro forma tax return at the time...

[00:23:06] Pamela Ritchie: AMT is?

[00:23:07] Jacqueline Power: Alternative minimum tax. If we don't pay enough tax essentially what happens is when you do this pro forma tax return it will determine if AMT would kick in. Now, if it's a high gain, unless there are lots of deductions and that sort of thing, hopefully, AMT wouldn't kick in but there are times where it does. I find AMT is definitely really quite common when businesses, in particular, are sold because of the lifetime capital gains exemption. With a cottage it may not be as likely to kick in but before they do this planning they should do a pro forma tax return just to get a sense for what is this going to look like.

[00:23:44] Pamela Ritchie: What it's going to look like, ultimately. Fantastic. Could you gift the cash to the kids and then sell the cottage to them at fair market value? Is that a route? I don't know.

[00:23:57] Jacqueline Power: If you're gifting the cash for them to  purchase it's a wash.

[00:24:02] Pamela Ritchie:  It's kind of the same thing.

[00:24:03] Jacqueline Power: Exactly. There wouldn't be any benefit to that. In that situation you would just gift the cottage to them because from a tax perspective it works exactly the same way as selling the cottage for fair market value.

[00:24:14] Pamela Ritchie: So great to have you answer all these. What is the difference in tax implications by gifting a cottage or buying at fair market value?

[00:24:22] Jacqueline Power: Same from a tax perspective. Exactly the same. Only difference is that you're not actually collecting those proceeds of sale.

[00:24:29] Pamela Ritchie: Got it. Can you discuss the principal residence exemption option that can be availed?

[00:24:34] Jacqueline Power: Yeah, for sure, as long as the property is considered to be ordinarily inhabited. For the time that the cottage is open, you go up most weekends, maybe spend a week up there in the summer, that's sufficient for it to be considered ordinarily inhabited. In that circumstance individuals can decide if they want to use the capital gain on the house in the city or on the cottage. Essentially, what they would do is at time of sale, or when the last person on title passes away, you look to see which property has appreciated more in value and then that would be the one that you would designate as your principal residence.

[00:25:11] Pamela Ritchie: Okay, this is going to the trust option. If the trust has control of the cottage who maintains ownership of the cottage, who is responsible for future expenses, taxes at the end of the year?

[00:25:23] Jacqueline Power: In that situation the trust owns the cottage.

[00:25:27] Pamela Ritchie: The trust itself. So it's a case of who's the trustee.

[00:25:28] Jacqueline Power: Yeah, and the trustee would control it but they're not responsible for for paying for everything. Where we normally suggest might be a good option is for individuals to have additional money that's in the trust that pays for the maintenance, that pays for the property taxes, so the beneficiaries themselves are not having to pay for that.

[00:25:49] Pamela Ritchie: A fund of some sort that throws off some cash.

[00:25:52] Jacqueline Power: Exactly, that allows those things to be paid for.

[00:25:57] Pamela Ritchie: Fantastic. Let's put this one to you. How much is the typical annual cost of having a trust? Lots of questions on the trust. Would the cost be worth the trouble?

[00:26:08] Jacqueline Power: That's a great question. Depending on trusts on an annual basis, it could be $1,500 to maintain, it really depends. It's really important to look at why is the trust being set up. Is it being set up to protect the beneficiaries? Is that something that's really important and that the cost is worth it? Every situation is unique. There are some situations where it would make sense, others where people say it's too expensive. The reasons, it all goes back to why do they want to establish that trust.

[00:26:45] Pamela Ritchie: That's really interesting. Why can the lifetime capital gains exemption not be used for a second property like a cottage or any kind of second property?

[00:26:54] Jacqueline Power: Principal residence exemption, I'm assuming, because lifetime capital gains exemption is for properties. The principal residence exemption, the reason it can't be used in more than one place is because the government says it can't. We're at their mercy. They allowed each spouse to have their own exemption up until December 31st of '81 but after that they decided that as a family unit you need to decide which property you want to designate.

[00:27:27] Pamela Ritchie: We'll put this one question and then we'll do a lightning round of the options of how we do this. Can someone add adult children to ownership and not trigger capital gains tax?

[00:27:40] Jacqueline Power: They could add them on, then in that situation they would just be legal owners of the cottage, not beneficial owners of the cottage. In that circumstance when somebody passes away it would be fully taxable within their estate so in that situation it generally wouldn't make sense to add them on.

[00:28:02] Pamela Ritchie: If we can go back to sort of the discussion of the different ways to pass on the collage. The first one that we went to was just sort of selling, taking the hit and passing it on to the next generation, selling. Can you go through the others just as we kind of round up here?

[00:28:18] Jacqueline Power: Then we can sell for less than fair market value but then we have the issues that arise as far as double taxation is concerned when we're doing that. We could gift it in that situation. It's the same from a tax perspective as far as selling at fair market values. Whoever received the cottage, their ACB would be the fair market value in that situation, or we can use the capital gains reserve. Those would be ways that they could transfer it.

[00:28:47] Pamela Ritchie: And the capital gains reserve, just to go back through this again,  it's something that takes place over time.

[00:28:53] Jacqueline Power: Correct.

[00:28:53] Pamela Ritchie: And that's sort of the beauty of it in terms of not getting hit all at once with capital gains.

[00:28:57] Jacqueline Power: That's exactly what it is. It would allow that gain to be spread over a maximum of five years. Any proceeds, if they are actually collecting proceeds of sale then any proceeds that are collected in a particular year the applicable gain would be taxable in that year. But if they're doing it as a virtual sale and no money is being collected then that, say, $500,000 gain could be split evenly 100,000 over five consecutive years.

[00:29:23] Pamela Ritchie: Fascinating. As we kind of wrap up this conversation what would you leave with investors, everyone who's speaking to their clients at this time of year, things to remember, what would be kind of a final thought or two?

[00:29:33] Jacqueline Power:  I would definitely encourage individuals to have their clients start thinking about this sooner rather than later, and also starting those conversations as early as possible. I know a lot of us think that everybody wants the cottage and that this is the be all end all but I think that once people understand the time and the cost that's associated with running that cottage then not everybody will want it. You wanna have those conversations sooner rather than later so that they're not going down this path that they think is what people want  when in reality it might not be something that's of interest to them.

[00:30:06] Pamela Ritchie: You just go on a big trip and stuff [inaudible].

[00:30:09] Jacqueline Power: Exactly.

[00:30:09] Pamela Ritchie: It is a delight to speak with you, Jacqueline Power. Thank you for joining us here at Fidelity Connects.

[00:30:12] Jacqueline Power: Thanks so much.

[00:30:13] Pamela Ritchie: Jacqueline Power joining us here right in studio. Coming up over the next few days, tomorrow do join us for a special two-hour regulatory Connects webcast starting at 11:30 Eastern Time. You can join Andrea Rigobon, she's Director and senior legal counsel at Fidelity. She brings together top experts in the regulatory field to discuss safeguarding integrity and trust, and conflict of interest and much more. It's a two-hour regulatory show tomorrow. That will be in many different languages. Andrea will present in English but it's available in live French, Mandarin and Cantonese audio interpretation so do enjoy that tomorrow.

[00:30:52] On Friday Director of Quantitative Market Strategy, Denise Chisholm, joins us to bring us her latest insights on the top sectors that are piquing her interest. She's also going to talk about the Fed's recent interest rate cut decisions and why they cut and whether that is bullish or not. So far looks bullish for markets, we'll discuss that.

[00:31:10] On Monday Fidelity Director of Global Markets, Jurrien Timmer, is going to be diving into the latest macro themes that are on his radar. He'll also share with you some pretty amazing and beautiful charts and graphs and data to help you kick off your trading week. Thanks for joining us here today. I'm Pamela Ritchie.