Your Cottage, A Family Tradition - Fall 2005

When he began building his cabin in Sioux Narrows, Ontario nearly 20 years ago, James O'Reilly never realized just how valuable the property would become: not in terms of material value - although in today's market it would fetch almost 100 times more than he originally paid — but in terms of its much treasured sentimental value.

"At first, I viewed it as an investment-they say you can never go wrong with real estate," says O'Reilly. "But after investing 20 years' sweat equity into what I now consider a labour of love, I realize weekend by weekend, I've been building a legacy."

A widower at age 64 with three adult children, ensuring the cottage remains in the family has become a priority for O'Reilly. And while transferring a secondary residence to a spouse at death is tax-free, it is a different story for children.

"Giving your child a cottage now or as an inheritance can trigger capital gains tax as a result of the change in ownership," says Martyn Hall, Rice Financial Risk Specialist. "If you haven't planned for this, there are some pretty serious consequences — the worst case scenario is your child sells the cottage to pay the tax."

The rising value in today's real estate market is a big factor. O'Reilly's cottage has appreciated in value by $600,000 over 20 years. This adds up to a hefty tax bill.

O'Reilly instead toyed with the idea of selling the cottage to his children for $1.00, hoping to undermine the impending tax.

"The tax implications are actually worse for both parties in that case," says Hall. "CRA (Canada Revenue Agency) will adjust to fair market value if the sell price is lower."

The good news is there are ways to plan for the taxes on this capital gain. If you can't afford to stash away funds or prefer a solution that allows the rest of your estate to remain intact, permanent life insurance is a good option to consider.

This way, your beneficiaries can use the life insurance to pay for the tax when the capital gains tax is applied.

"I don't want my kids to pay out-of-pocket for what I consider a family tradition," says O'Reilly. "But I do want the cottage to stay in the family. It was an easy decision."

As the industry saying goes, life insurance costs less than real money. Instead of saving dollar for dollar to cover the tax liability, O'Reilly is able to cover the amount for only pennies on the dollar.

Now with the logistics set aside, O'Reilly is free to enjoy the fruits of his labour. For estate plans tailored to your personal situation, contact your Rice Financial representative.

To calculate the capital gain, Canada Revenue Agency (CRA) assesses the cottage and property based on its fair market value at the time of the change in ownership. O'Reilly's cottage originally cost $70,000, but is now worth $670,000. CRA applies tax to half of the increase, in O'Reilly's case $300,000. In the highest tax bracket, the tax amounts to over $135,000.