Estate planning for the family cottage--Part Two.

• Author: Taerum, Chastine M.
• Position: Tax law

In Part One, we discussed two key issues regarding the estate planning of the family cottage: inheritance and ownership structures. In Part Two, we will discuss taxation and governance.

Taxation Issues

When a taxpayer dies, there is a deemed disposition of all the taxpayer's property at fair market value under subsection 70 (5) of the federal Income Tax Act. This deemed disposition occurs despite the transfer of the taxpayer's property to his or her children or to a trust for their benefit. (A tax-free rollover can occur if the taxpayer transfers the property to his or her spouse or transfers farm property to his or her children, but this is beyond the scope of this article.) This may lead to a significant amount of capital gains if any capital property of the taxpayer has appreciated in value. The Canada Revenue Agency has, over time, reduced the number of options available to reduce income tax on capital gains from the disposal of capital property.

Prior to January 1, 1982, it was possible for each spouse to designate a separate property as his or her principal residence. This effectively allowed one spouse to elect the city home as a principal residence and subsequently reduce the capital gains subject to tax on a disposition and also allowed the other spouse to elect the family cottage as a principal residence and reduce capital gains on its disposition. However, the concept of a "family unit" was introduced in 1982 which effectively eliminated this option. Each year after December 31, 1981, the spouses who constitute a "family unit" can only designate between themselves one principal residence. It is now prudent for spouses who own more than one residence to determine which residence has the greatest accrued capital gains. The residence with the highest accrued gain should most likely be designated as their principal residence.

Prior to 1992, it was possible for taxpayers to dispose of their remainder interest in their property to their children and retain a life estate for themselves without any income tax consequences upon the taxpayer's death. This opportunity led to the introduction of section 43.1 in 1992. Now, if the taxpayer transfers the remainder interest of the cottage property and retains a life estate, section 43.1 will apply. The application of section 43.1 to this situation was aptly summarized by Martin J. Rochwerg in "Tax Considerations in Choosing the Right Entity for Holding Family Investments and Business," 1993...