Your Cottage is a Tax Time Bomb!

Well what a year it has been! Summer of 2020 will not only go down as one of the most bizarre in modern history, but also as the hottest summer in 84 years! I'm sure many of you by now have prepped for the Winter, closed the doors for the season and are still basking in the afterglow of Family Cottage Experience 2020! As you fondly remember the time spent with your family at the cottage and look forward to next year, there's something else that also needs your attention. You may be sitting on a tax time bomb.

What Tax Time Bomb?

The Income Tax Act (Canada) (ITA) contains a "deemed disposition" rule meaning that when a taxpayer dies, the ITA considers the taxpayer to have disposed of ALL capital properties immediately before death and to have received proceeds equal to the fair market value of each property.

Your cottage is subject to this rule, unless a spousal rollover is available and would delay the "deemed disposition" tax implication to the time of death of the surviving spouse. So, when you die, you'll potentially leave behind a tax liability for your loved ones to deal with. If the value of your cottage has increased since your acquired it, this increase will be considered a capital gain. One-half of this gain is included as taxable income in your final tax return, resulting in a tax liability. Depending on the increase in value, the tax liability could be substantial. This liability can erode the liquid portion of your estate that's available for distribution to the people you love. Worse, if your cottage forms a significant portion of your estate value, your children, might be forced to sell the cottage, or incur debt to raise the money required to pay the taxes. Obviously, you would prefer your children to inherit the cottage, not just the tax liability associated with it!

How big could this tax liability be?

This depends on factors such as adjusted cost base (which is generally the purchase price of the property and any capital improvements), the fair market value of your cottage and your tax rate in your final year. It also depends on whether you have any unused capital losses available to offset the capital gains, and whether you rollover the cottage to your spouse (spousal rollover). Your principal residence exemption may come into play here as well.

Let's assume Maxine and her husband Zachary had a cottage that was originally purchased 25 years ago for $300,000. Since then a lot has happened, their 4 kids are all grown up and Zachary died a few years ago so the spousal rollover occurred with respect to the cottage at that time. From the time of initial purchase, Maxine and Zachary spent about $100,000 in capital improvements. Unfortunately, Maxine died today and the fair market value of the Muskoka Cottage is worth $2 million. In this example, the taxable capital gain is $800,000 ($2million minus the $400,000 x 50%). The tax owing on the gain would be at Maxine's marginal tax rate X the taxable capital gain (45% X $800,000) = $360,000.

Tick….Tick..Boom!

On top of the tax bill of $360,000, there is also estate tax (probate) that need to be considered and dealt with.

  • Would you want the cottage, which is associated with joy and happiness to your family, to now become a burden soon after you are gone?
  • While your family wants to keep the cottage, how would they feel if they are forced to sell the cottage to pay the tax bill?
  • Would you want your children and grandchildren to continue enjoying the cottage for years to come?

What's the solution?

Purchasing a single life policy, or a joint and last to die policy on you and your spouse that's sufficient to meet the estimated tax on the "deemed disposition" and probate fees would potentially be the easiest and most cost effective solution this looming problem. The beneficiary of the policy would be the estate, or the heirs can be named beneficiary. On your death, (or on the death of the last spouse), the policy tax free benefit is paid out to the beneficiary(s). Your Executor, can then use the money to pay the tax bill owing from the deemed disposition of the cottage thereby preserving the cottage for the enjoyment of your family. If there's money leftover it can form a fund that could be used for cottage maintenance costs and capital improvements for the future.

For this solution, action is required on your part and the sooner the better! Life insurance premiums may increase as the age or ages of the life or lives to be insured increases. Also, there is NO GUARANTEE that you will be insurable in the future which is why it is important to act.

Equalizing the Estate

Another benefit of life insurance is that it provides LIQUIDITY to your estate and can help EQUALIZE your estate, especially where the value of the cottage is significant.

While distributing the estate, it may be difficult to decide how to distribute the cottage between the children. Often, the more children in the family, the more complicated this becomes. It may be easier to have one child inherit the cottage and provide equalization in other ways to the remaining children. If sufficient life insurance is purchased, payable to your children as beneficiary(ies), then it's possible to make adequate provisions for them. The children who are not inheriting the cottage can receive money from the death benefit of the life insurance. This would reduce the risk of acrimony as a result of perceived inequity AND it would be easier for the management of the cottage in the future when there are fewer people involved in the decisions of maintenance, cost sharing etc.

Life insurance can make this fair for everyone!

The "deemed disposition rule in the Income Tax Act may transform your cottage from being a source of joy and happiness, to a tax burden on your children or creating estate inequity after you die. Life insurance is potentially the simplest and easiest solution to these emotional and expensive problems.

We can help structure a solution that ensures fairness, tax efficiency and simplicity! It's certainly something to think about and act on during the "off season".


Martin Maretzki, B.Comm (Hons.), CHS, CLU