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Leaving the cottage to the kids: a gift that could be costly - DFSIN - SFL

Leaving the cottage to the kids: a gift that could be costly

A second home is often associated with priceless family memories. What could be more natural than wanting to leave it to the children when you pass away? Be careful, though: some planning is required... especially in the wake of the federal budget tabled in April 2024.

June 06, 2024

The budget tabled by the federal government last April made plenty of people who own second homes realize that their property came with what could be a substantial tax bill. In fact, for tax purposes, a second home is treated differently than a principal residence, and this can complicate a number of issues, especially when it comes to handing it over to the children. 

What is involved, and what has changed since the last budget?  

A five-point explanation. 


1. Why is there tax on a second home? 

For tax purposes, a second home, whether a family cottage, country house or ski-slope condo, is treated in the same way as an income property or a mutual fund* investment. It’s an investment that could be sold at a profit, and this profit – known as a “capital gain” – is taxable. Thus, a second home does not have the same status as your principal residence, which is tax-exempt. 


2. How is a second home taxed? 

The gain realized on a second home becomes taxable upon “disposition” of the property. Typically, three situations can trigger this disposition: the sale of the property; its transfer (to the owner’s children, for example); or the death of the owner. In the latter two cases, it is known as a “deemed disposition” even if the property is not actually sold. 

Regardless of the form of disposition, the taxable capital gain will be determined according to the principles illustrated in the diagram below.  

As we can see, the full capital gain is not included in the taxable income. The taxable portion is based on the “inclusion rate” set out in legislation. Until June 25, 2024, the inclusion rate is 50%, which means that only half of the capital gain has to be included in the seller’s income. In our example, $212,500 would be taxable at the person’s marginal tax rate. If we assume, strictly for illustrative purposes, a marginal tax rate of 50%, the tax payable would be $106,250. 


3. What will change on June 25? 

For individuals, there is a provision in the 2024-2025 federal budget to increase the capital gains inclusion rate from 50% to 66.6% (i.e., from 1/2 to 2/3), for all capital gains over $250,000 within a given year. Here is how that would affect the example above: On the first $250,000, the taxable portion would be $250,000 X 1/2 = $125,000. On the remaining $175,000 above the $250,000 threshold, the taxable portion would be $175,000 x 2/3 = $116,666. Still assuming a marginal tax rate of 50%, the tax payable would thus be $62,500 on the first portion and $58,333 on the second portion, for a total of $120,833. 

For businesses, it’s important to note that there is no $250,000 threshold. If you, like many entrepreneurs or professionals, have a holding company, and it is the company that owns the property (for example, for seasonal rentals), the new inclusion rate would apply to the whole capital gain realized. In our example, the taxable capital gain would thus be $425,000 X 2/3 = $283,333, for a tax bill of $141,666, still assuming a marginal tax rate of 50%. 


4. What that means for your children 

If you are planning to pass your second home to your children after your death, you need to be aware of two things. First, that your estate would have to pay taxes before the property is transferred and, second, that this tax bill might be larger than it would have been before the new provisions. This means that if your estate does not include other assets that could be used to cover the tax, your heirs might be forced to sell the second home you wanted them to have, just to pay the bill.  


5. Ways to soften the blow 

There are various ways of dealing with this situation. One consists of making a legal designation of your second home as your principal residence, but in that case your other residence would become taxable. Some careful calculations would be needed to come up with the best decision. Another option would be to transfer your second home to your children during your lifetime. That would involve a deemed disposition and you are the one who would have to pay the capital gains tax. In other words, you would need to have sufficient funds available to do that. 

The most common solution is simpler: buy a life insurance policy approximately equal to the amount of tax to be paid upon your death, including that on your taxable capital gains as well as any tax on the assets in your tax-deferred accounts, such as a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF), which would also be subject to deemed disposition. That way, your children would inherit a net estate, with the tax already taken care of thanks to the life insurance policy.  

Note that if you have a surviving spouse, your assets could be passed to him or her tax-free. But that would only postpone the scenarios discussed here until your spouse’s death. 

Your advisor can help you review your options and decide which approach would be the most suitable. Feel free to consult him or her.  

* Mutual funds are offered by group savings representatives at SFL Investments, a financial services firm.