The family cottage is probably the most emotionally charged property for most Canadians. Keeping the cottage in the family and passing it on from generation to generation would be what most cottage owners dream of and even take for granted.

Yet, what most cottage owners leave out of the equation is the tax liability at death and the impact it can have on diminishing their estate and in some cases in making it virtually impossible to pass on their beloved family cottage to the next generation.

According to Canadian tax law, your assets are deemed disposed at fair market value at death. This means that your estate will incur a capital gains equivalent to the fair market value of the property minus its adjusted cost base (this usually comprises the purchase price of the cottage plus the cost of any renovations or upgrades). Half of the capital gains incurred on the deemed disposition of the property at death will have to be included in your income in the year of death and will be added to any other income you would have had in that year and thus will be taxed at your top marginal tax bracket.

To illustrate this, let’s look at an example. Joe and Mary purchased their cottage in Muskoka in 1983 for $50,000. Joe passed away in 2005 at age 82 and since the property was jointly owned with Mary, the ownership passed on to Mary without any taxes being payable on Joe’s death. Mary subsequently passed away in 2010. The fair market value of the cottage in 2010 was $610,000. Joe and Mary had spent $60,000 in upgrades and renovations during the years. Therefore their cost base for tax purposes was $110,000 ($50,000 purchase price plus $60,000 cost of renovations).

The capital gains realized in 2010 upon Mary’s death was $500,000 (Fair market value of $610,000 minus adjusted cost base of $110,000). Half of the capital gains ($250,000) had to be included in Mary’s income in her final tax return in 2010. Since she had $80,000 in pension and investment income in 2010, she had $330,000 as her total income for tax purposes in 2010. Therefore the tax that her estate had to pay on the $250,000 extra income she had due to the capital gains realized on the deemed disposition of her cottage was approximately $115,000.

Mary’s estate was given up to 12 months to pay this tax bill, or else Canada Revenue Agency (CRA) could force a power of sale to settle the tax bill. Mary’s heirs faced a few tough choices. None of the alternatives were ideal. They did not have the cash to pay the tax bill, nor did they have the resources to borrow the money needed to settle the tax bill. Therefore they were forced to sell the cottage at an unattractive price in order to come up with the cash needed to pay the taxes, an outcome that was a far cry from what Joe and Mary had envisioned for their favourite property and for their loved ones.

As always, a bit of estate planning done in advance can go a long way in minimizing the taxes arising on death. Setting up a family trust, joint ownership with children and gifting the cottage to children are all possibilities that can be considered as part of estate planning when it comes to the family cottage. However, they involve legal and accounting fees, realization of the capital gains taxes (at the time of transfer to the trust or change of ownership) and loss of control over the property (in case of joint ownership with children or gifting to children).

The least costly way of making sure the cash is going to be available at death to pay the capital gains taxes while ensuring that one can retain full control of the property during one’s own lifetime, is purchasing a “joint last to die” life insurance policy. This option, which is less costly than purchasing separate policies on each spouse, would of course only be available if you can meet the medical underwriting guidelines.

If Joe and Mary had obtained a “joint last to die” life insurance policy with a death benefit of $115,000, upon Mary’s death (the last spouse in this case), her estate would have received $115,000 tax free that her heirs could have used to pay the tax payable on her final tax return.

Capital gains taxes are only one of the major costs that an estate will face. Probate fees and executor fees need to be taken into account as well. The sooner you put some thought into your estate planning, the more options you will have available to you and the less costly those options will be. W

• Tina Tehranchian (905.707.5220, tinatehranchian. com) is a branch manager and financial advisor at Assante Capital Management Ltd. in Richmond Hill. Please contact a professional advisor to discuss your particular circumstances prior to acting on the information above. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.