Succeeding at succession

Drafting a cottage inheritance plan can help avoid family infighting and miles of red tape, not to mention endless banking bureaucracy.

by Andrew Cruickshank

The family cottage has long been valued for its tranquility and regenerative qualities, but the COVID-19 pandemic has cottagers rethinking their property’s other values, namely its monetary worth.

Any cottage owner who’s glanced at a recent real estate listing will have a hard time picking their jaw back up off the ground as they watch neighbouring properties sell for dizzying prices.

Cottages are hot commodities. The booming market has launched many owners into a delighted jig, but an aging cohort of baby boomers now have a valuable piece of property on their hands and must figure out what happens to it when they’re gone.

This very question confronted my family last year. Our cottage – a cozy bungalow built on a sandy point overlooking one of Kawartha’s pristine lakes – has been on my mom’s side of the family since the 1930s when my great grandfather bushwhacked his way into unchartered territory. The log cabin he built still sits on the property, cobwebbed and dark, while a more “modern” cottage – one with indoor plumbing and electricity – built in the 1950s sits closer to the point.

It’s a cherished spot for everyone in the family, filled with a lifetime (or two) of memories. That’s why, last year, when my grandfather turned 90, my mom and her three siblings realized they needed to sort out how the cottage would be passed down.

To help with the matter, they turned to Peter Lillico, a Peterborough lawyer with countless years of experience in cottage estates and mediating family egos.

The first thing Lillico will tell you is that each succession plan is unique. “What works for your neighbour isn’t always what’s best for you,” he says.

There are scenarios, however, that every cottager needs to consider. Last month, in a webinar put on by the Federation of Ontario Cottage Owners’ Associations (FOCA), Lillico outlined what these scenarios are. The conversation we had following the webinar filled in some of the details.

Assess your family situation

It is imperative to have a cottage succession plan because, without one, your children will be left fighting red tape and banking bureaucracy.

The first step is to figure out who you’re passing the cottage on to. If you have one child, the answer could be fairly straight forward. But Lillico stresses the need to assess your child’s level of interest in the cottage, whether they’re sufficiently living near enough to look after it, and whether they’re financially stable enough to afford the taxes and maintenance associated with the property.

This question becomes more complex with additional children.

“Don’t wear rose tinted glasses,” Lillico says. “I’m sure that you say, ‘oh, my children are all lovely, and I think that they’re great,’ but that does not make each child equally appropriate to be a cottage owner.”

In my family’s case, succession was complicated by four children, each of whom were interested in the cottage despite one living in the United States, so the cottage ownership was split into four equal parts.

Your own children may be different. Don’t assume interest. Talk to them about the costs and responsibilities of owning a cottage before gifting them a piece.

Create a cottage sharing agreement

Once you’ve ascertained who will be inheriting the cottage, it’s time to work out the ownership details in a cottage sharing agreement. This an opportunity to outline your wishes for how the cottage is looked after, and, if you have more than one child, how the cottage will be jointly owned.

Often, this is where family egos emerge and tempers flare.

The sharing agreement is a legally-binding roadmap that your children must adhere to. It’s the document where families stake claims to which months they’ll visit the cottage, as well as smaller details, such as who pays for maintenance, boat storage and more. My family dug into details as specific as which trees could be cut down. It’s important that these points are ironed out in the agreement so that there’s no need for legal action later.

According to Lillico, this is a good opportunity to see whether your children can handle joint ownership. If one child is demanding that it’s their way or the highway, maybe you’re better off selling the cottage.

Capital gains tax

The dreaded capital gains tax – it keeps even the heartiest cottage owner up at night. For those unfamiliar with the levy, this is the tax you pay on your property’s appreciated value, from when you bought it to when you relinquish ownership.

For example, if you bought your cottage 20 years ago for $200,000 and now that cottage’s fair market value is $800,000, then it’s appreciated $600,000 in value. When you sell or pass on your cottage, 50 per cent of that appreciated value ($300,000) is added to your income for that year. This will likely knock you into the top tax bracket, pushing up your marginal tax rate. These rates change each year, but most recently the top bracket has hovered around 33 per cent, meaning that if your cottage has appreciated by $600,000, you’d have to pay approximately $99,000 in capital gains tax.

This may seem daunting, and many property owners complain about the lofty sum, but the fact that you have to pay so much shows that your property appreciated in value rather than depreciated and you’ve got “the best problem you could possibly have,” Lillico says.

You don’t have to pay capital gains tax on your principal residence, but you can only have one principal residence at a time (this applies to married and common-law couples, as well as individuals). If you own a home and a cottage, you have to choose.

There is flexibility here, though, Lillico says. Your principal residence doesn’t have to be the property you live at full time. If you visit your cottage for a couple weeks each summer, it can still be considered your principal residence.

You can also transfer principal residency from year to year, so your home could be your principal residence for five years and capital gains much more complicated).

When determining which property to make your principal residence, Lillico advises choosing the one that has appreciated more in value. If your home’s fair market value has appreciated by $100,000 while your cottage has appreciated by $500,000, you’re better off choosing your cottage. This will result in lower capital gains tax.

Lillico also says you should be strategic about when you implement your principal residence exemption. The exemption takes effect when you sell the property or pass it on to your beneficiaries. Rather than transferring the cottage to your children early, you may be better off keeping the cottage in your name until you die so that the exemption applies to any value appreciated during your lifetime.

For those concerned about dumping capital gains tax on their children, there are strategies to mitigate the payment. According to Lillico, life insurance is an effective strategy.

“Some clients consider buying life insurance while they’re still insurable,” he says. “The costs are relatively low because you’re still young and healthy. The idea would be you’d buy $300,000 worth of life insurance on a joint last-to-die basis. This means that when both parents have passed away, $300,000 will kick in to apply to the capital gains tax.”

Keeping it in the family

No one wants to watch their family cottage torn apart by a messy divorce or a bankrupt beneficiary. To ensure the cottage stays in the family, Lillico advises transferring the cottage to a sprinkling cottage trust.

“If there’s a marriage breakdown, the Ontario Court of Appeal has held that if the cottage is in a sprinkling cottage trust, it does not come within the definition of a matrimonial home and is therefore exempt from claims on separation or divorce,” he says. “And creditors who say this individual child owes $100,000 can’t attach the debt to the cottage because it’s in an asset protection trust.”

You will have to pay capital gains when transferring the cottage into the trust, but rather than being named owners of the cottage, your children become trustees. The cottage can then remain in the trust for 21 years before the trust’s assets must be disposed of. At this time, your children can either pay the capital gains accrued after 21 years and place it back in a trust, or they can name your grandchildren beneficiaries of the cottage and no capital gains need to be paid.

Be prepared, be organized

There are so many minute details involved in a cottage succession plan that it deserves an entire book. But it’s important that you are prepared when it happens. My family spent hours combing through their succession plan over Zoom calls. Less than a month after the plan was solidified, my grandfather died. Our cottage sharing agreement is now in effect.

The reality is you never know how soon you’ll need your succession plan. Procrastinating ends in paperwork and legal bureaucracy during a time normally reserved for grief. To ensure you have an effective plan in place, contact a legal professional.

And remember that perspective is important. As many of the accountants and lawyers I spoke to for this story told me, a cottage is just a structure – it’s not worth breaking up a family over.