Inheriting a Secondary Residence? Some Planning May Be Required

When someone leaves you a cottage or vacation home, you’re inheriting something with sentimental and financial value – but could also have tax considerations. It’s the kind of gift that can raise unexpected challenges.

April 14, 2018

A country cottage or second residence is usually associated with cherished family memories. That’s why parents are often so eager to leave these properties to their children. The only problem is the income tax payable on that gift could require the heirs to pay dearly for their inheritance.

Tax on a Second Home

Unlike a principal residence, which is not subject to capital gains tax, a second home is part of the taxable assets a person is considered to have disposed of upon death. Before the asset can be transferred to the heirs, the estate of the deceased must pay any capital gains tax due.

A graphic showing the tax payable at death from a principal residence and a secondary residence. If both properties were purchased for $350 000 each and were valued at $700 000 at the time of death, tax would be payable only on the secondary residence. The capital gain of $350 000 – derived from the difference in original cost and market value at death – has an inclusion rate of 50%. Therefore, $175 000 is the taxable amount added to the deceased’s income tax return.

There is one noteworthy exception: Just like an RRSP or RRIF, which can be transferred - or “rolled over” to use the technical term - to a spouse’s plan, a secondary residence can also be rolled over to a spouse, tax-free.

Possible Problems

As you might imagine, the tax situation could lead to various problems when the estate is being settled:

If there is not enough liquidity in the estate to pay the tax, the children could be forced to sell the property in order to pay the tax bill.
If the secondary residence is left to one heir, an adult child, for example, but other assets - such as the primary residence – is left to a surviving spouse, it could create conflict. The secondary residence would be taxable but the primary residence would not.
Similarly, if the children have different intentions as to how the property should be used, the fact that it comes with a tax bill could aggravate the situation.

A Few Strategies

The following solutions are generally used in estate planning when a secondary residence is involved:

Purchase Life Insurance
This is the most common solution. A life insurance policy covering future capital gains tax on the secondary residence might not be too expensive for the home owners to purchase, and the children as heirs could even pay the premiums themselves. Such a policy might also cover taxes payable on the disposition of the parent’s RRSP, RRIF and taxable investments, which could allow the children to inherit the capital intact.
Increase the Adjusted Cost Base
Since capital gains are calculated based on the adjusted cost base of the property, it could be extremely important to document any major renovations done over the years. In our illustration above, if $200,000 had been invested in improving the property, the adjusted cost base might rise to $550,000 and the taxable capital gain would be $100,000 instead of $175,000.
Make the Secondary Residence the Principal Residence
Under certain conditions, the law allows you to designate the property of your choice as your principal residence. Provided you meet the conditions, you can then choose which property to shelter from capital gains tax: if the country cottage is likely to generate a higher tax bill, it could be to your advantage to designate it as your principal residence. Your heirs will still have to pay the capital gains tax on the other property, but the tax bill will be lower than it might be otherwise.
Transfer Ownership of the Secondary Residence While You Are Alive
Ownership of the property may be transferred to children while the parent is still alive, either as a gift or via a family trust. The property will then be considered to have been sold at its fair market value, and the parent will have to pay the capital gains tax immediately. However, any future capital gains will accrue to the children when they die or sell the house. In provinces where estates are subject to probate fees, this strategy might also reduce the value of the estate, and thus reduce the fees. Note that a number of conditions apply.

And Consider What the Beneficiaries Think

It could be a good idea to consult the children and take their plans into account; maybe they don’t want the family cottage! Or maybe it can be shared among many children; a co-ownership agreement is often recommended. If the children are involved in the conversation, drafting the agreement will allow for everyone’s financial and lifestyle considerations to be taken into account.

As you might imagine, seeking informed advice when incorporating a secondary home into a will and estate plan can make a huge difference when the property is transferred.