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Don't Risk Losing The Family Cottage - Tips To Avoiding Cottage Conflicts
By Arthur Drache - 2002

With the advent of summer, hundreds of thousands of Canadian families will spend at least some part of their time at the family cottage, away from the demands of urban life. So it is not surprising that children, in particular, harbour warm and sentimental feelings toward the cottage.

Consequently, as almost anyone who advises on estate planning will attest, family cottages generate some of the most acute planning problems. There are two distinct issues in play. The first is the question of taxes that might be payable when the owner dies and wants to leave the cottage to the next generation. The second revolves around making arrangements for the next generation (if there are two or more children) to share the use of the cottage.

Ironically, the family cottage usually generates more problems than the family home. Few children anticipate moving into their parents’ home once the parents die. But there is an emotional aspect to cottage ownership that is seldom present with an urban house, and more than one family feud has started when well-meaning parents leave the cottage to two or more siblings.

But let’s look at the tax issue first. Until the end of 1981, each family could, with basic planning, own two “principal residences.” This was achieved by having both spouses jointly own each of the family home and family cottage, or having one spouse own the home and one own the cottage. The significance of the principal residence rule is that there is no capital gain on the disposition of the residence, either on sale or at death.

However, in 1981 the rules changed. Now they allow a married couple to have just one principal residence between them. To complicate life a bit, when there are two such residences, the cost base for tax purposes is deemed to be fair market value as of December 31, 1981.

Whether a particular dwelling is a principal residence is determined when it is disposed of, not in advance. So the issue of how to treat a sale or other disposition arises only when the disposition takes place. In practical terms, however, you may find that the decision has already been made without giving the issue much thought.

Consider Max and Jane Green, a married couple. In 1972, when the capital gains regime was introduced, they owned a house with a fair market value of $100,000 and a cottage worth $40,000. They decided, having taken advice, to register the house in the name of Jane and the cottage in the name of Max. At the end of 1981, the house was worth $150,000 and the cottage was worth $75,000.

In 2002, they decide to sell the house (which was then worth $250,000) and move into a condo. The cottage, which they were not selling, is now worth $125,000. Though they didn’t think about it when they sold the house, they had a choice. They could take the position that it was their principal residence and the full gain would be tax-free. Alternatively, they could have decided to treat the cottage as their principal residence by deciding to pay tax on the house sale.

If they opted to pay tax on the house sale, they would have had a capital gain of $100,000, the $150,000 value in 1981 becoming the cost base. Making this decision would ensure that any gain on the cottage would be free of tax when it was disposed of – probably when they died and left it to their kids. Now at that stage, the potential gain on the cottage was only $50,000, using the 1981 value. So, the rational approach would be to elect tax-free gains on the house, which they did.

The cottage is now a ticking tax time bomb. Its cost base is $75,000 but there is a potential tax liability that grows as the value increases – if it does. The usual approach is to take out second-to-die life insurance to guarantee that funds are available to pay the tax when both parents are gone.

But, if you are prepared to bite the bullet now and pay tax, you can set up matters so that the tax on future gains is postponed indefinitely by taking the following steps:

Max and Jane set up a corporation with no shares (a membership company) that will be exempt from income tax under paragraph 149(1)(l). They are the founder members and each have 10 votes at any meeting. Each of their children have a single vote. Membership is limited to their direct descendants and membership is not transferable except within the eligible class. Membership ceases at death.

Max and Jane transfer the cottage into the new corporation either by way of gift or by way of sale, taking back a note or mortgage. Either way, this triggers a tax bite based upon fair market value at the time, though it can be spread over a few years through the use of a reserve. The corporate debt is either forgiven or the kids contribute an annual amount that is used to pay down the mortgage debt. The parties involved also pay an annual amount to meet expenses.

When the parents die, their membership rights also die, so that there is nothing that would be brought into the estate. The kids remain members and control the corporation and the cottage.

Under the general rules applicable to non-profits under section 149 of the Income Tax Act, if the cottage is sold by the corporation and the funds are distributed to the members, it would be treated as a capital gain with the ACB being the amount of fees paid for membership. (See step 2 with regard to funding.)

The bylaws of the corporation should set out the rules about usage of the cottage and perhaps set out procedures so that two or more families (who are the members of the corporation) can work through the problems that will inevitably result. We caution that the more kids Max and Jane have, the greater the difficulties and, as generations pass, these difficulties will be exacerbated.

There may have to be bylaws that cover such things as the buy-out of a member, perhaps by way of a cancellation payment by the corporation.

Our experience indicates that this approach to cottage ownership works, but only if the process is approached in much the same way as a commercial arrangement with a stranger is approached – with caution and with the assumption that bad things might happen. That may not seem to be appropriate in a family tax-planning situation, but given the problems that occur about cottage access, it is the most prudent course.

Copyright 2002 by Arthur Drache. All rights reserved.

For further information, please call our office, visit our website at www.deboski.com.

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