Thursday, July 14, 2011

MARKET TRENDS: Selling the Family Cottage to Your Children

When you're a kid, the family cottage means long, fun days playing outside during Canada's brief summer season. When you become a teenager you can invite friends and the cottage becomes party central. When you become an adult and your parents pass the cottage on to you and your siblings, it can become a battlefield.

If you have a family cottage, now is the time to gather everyone together to discuss what will become of it. Without financial planning, there's a real possibility that your children will have to sell the cottage to pay off the fees and taxes that will come due when you pass away. The other conversation must be about the lifestyles of your children and whether all of them (and their spouses) want to keep the cottage or sell off their share.

"Sentimentality around the family cottage or cabin doesn't have to calculate into stressful emotions," says Elaine Blades of Scotia Private Client Group. "There's no right answer here, so it's important to look at the destination. Look at what the family wants to happen and work backwards while working with an expert who can anticipate all scenarios to help get there. By starting the succession conversation, adult children often find they're doing their parents a favour. Have the discussion and have it now."

The first task is to determine if the children want to continue owning the cottage. What if one sibling wants to keep it but another one wants to sell? Those who want to keep the cottage may not be able to afford going it alone. Can the child who wants out sell his share to a third party? If a sibling dies, does his share of the cottage go to his spouse and children, or to his siblings? What happens if one of the siblings has a marital breakdown and the cottage is part of the division of his assets? Should the spouses be asked to sign a prenuptial agreement that excludes the cottage as one of their shared assets?

If your children are still too young to participate in these discussions, one suggestion is to purchase a life insurance policy as early as you can. The proceeds from the policy would be designated to buy out the children who don't want to keep the cottage.

If the cottage is to be passed on, Capital Gains Tax is the biggest financial hurtle to overcome. The legal firm Lillico Bazuk Kent Galloway of Peterborough, Ont. says, "Your goal is to pass the cottage over to the children without bankrupting yourself or your estate. There are legitimate ways to reduce the tax bite."

If you plan to transfer the deed while you're alive, it can be done in stages rather than all at once, the firm says. For example, transferring 20 per cent for five years would reduce the tax hit. However, the firm cautions that even if the cottage is being transferred as a gift, it counts as income for tax purposes, and the amounts must be based on fair market value of the cottage. This "income" could have unintended consequences, such as creating a clawback on your Old Age Security benefits.

Another option might be to declare the cottage as your "primary residence", which is exempt from the Capital Gains Tax.

Lillico Bazuk Kent Galloway says that for ongoing maintenance of the cottage, a testamentary trust is a good solution. A family trust is set up in your will that is to be used exclusively for cottage purposes.

"It enables all or a significant portion of the operating costs to be paid from the trust, rather than from the children's own pockets," says the firm. "If there is need for a substantial expenditure, then the trust capital can be encroached upon for that purpose, avoiding a financial emergency. The use of a testamentary trust compensates for the difference in economic positions between the children, to the benefit of all."

If you don't think your children will be able to get along, but you're not ready to give up the cottage yet yourself, another option is to gift or sell to your children but retain a life interest in the property. Your children must agree to this condition or the cottage won't be sold. It prevents them from selling or mortgaging the cottage without your consent, or – heaven forbid – keep you from using it.

Once the cottage has been passed on to the children, some ground rules must be determined about how it will be managed. Who will open and close the cottage? Will everyone be there at the same time, or will the siblings determine a schedule of when everyone can go? How will ongoing maintenance and taxes be paid? How will major repairs be funded?

Blades says that "in this day and age, families are often more like the Brady Bunch than the Cleavers." Some loving families will have no problem figuring out how to share the financial load and the social life of the cottage. Other siblings may end up in court unless there's a prior legal agreement.

The solution is a written Cottage Co-Ownership Agreement, says Lillico Bazuk Kent Galloway. "You can create this as a family or prepare one with your lawyer. As a written contract, the agreement should be legally enforceable…The parents can serve a leading role in encouraging the creation of this cottage-saving device and in facilitating compromises."

The agreement could cover everything from decisions about when it's time to build a new dock, to how it would be handled in future if a child wanted to sell.

"Cottage succession touches all aspect of wealth management planning and those plans must be aligned," says Blades. "For parents, there can be implications for retirement income and philanthropy. For children, what exactly are they taking on and how does that affect the wealth they are in the process of building for their family? "Seek out options that address the entire family unit's goals."

Jim Adair July 5, 2011

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