If you are successful in passing on your cottage to the next generation, avoiding the many difficulties and pitfalls, congratulations!

However, there are still serious risks to be overcome to ensure that the cottage stays with your children, and is not soon sold because of internal fractions that will inevitably arise. The really is that in most families, there will be a difference in the children’s incomes and financial resources. This must be addressed before it becomes a crisis.

For example, if the cottage is left to your son and daughter jointly, it may be that your daughter can easily afford to carry her share of the cottage expenses of heat, electricity, taxes, insurance and maintenance. Your son may be handling all he can by simply keeping up his own home, with little or nothing left over to pay his share of cottage expenses.

This situation inevitably leads to stress, with the daughter exasperated that she is always having to chase her brother for his financial contributions, and the son resentful of the ongoing financial pressure.

This ongoing irritation can become a crisis when a major expenditure is required, such as for a septic system replacement, a new roof or structural repairs. The result is that the cottage can quickly become a source of contention rather than family fun. All too often, this leads to family strife and a sale of the cottage to remove the root of the problem.

A solution with considerable merit is for the parents to leave a certain sum of capital in trust by their Wills, to be used exclusively for cottage purposes.

This is referred to as a testamentary trust. It enables all or a significant portion of the operating costs to be paid from the trust, rather than from the childrens’ own pockets. Furthermore, if there is a 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 differences in economic positions between the children, to the benefit of all.

When parents are alive and active, it is relatively easy to apportion the many cottage responsibilities among the children. However, when the parents are no longer available to act as mediators and facilitators, far too sibling strife breaks out. Just a few of the disputes that may arise include questions such as:

• Who is to open and close the cottage?
• Who is responsible for organizing the payment of bills?
• Should the cottage operating and capital costs be shared equally, or in proportion to income, or in relation to use?
• Is the cottage equally available at all time for all siblings, or are they to take turns having exclusive use?
• How are the turns to be allocated, and who gets the long weekends? Is use restricted to family only, or can anyone bring along a gang of friends?
• If one of the children has a financial crisis, brought on by loss of a job, or a marital breakdown, or simply too much debt, can that child force the sale of the cottage and a division of the net proceeds?

Some of these issues may sound trivial, and some second generation families do successfully navigate them by the seat of their pants.

Unfortunately, many other families hit deadheads. The result can be that the cottage and its use becomes a bone of contention rather than a focus of family fun. Sadly, it is not uncommon for the cottage to be sold in these circumstances. A joint ownership agreement, negotiated while the parents are alive and able to assist, can be invaluable in retaining family harmony and enabling successful second- and third-generation cottaging.

Parents with more than one child may often face a dilemma when they are planning to pass the cottage on to the next generation. Should the cottage be left to all, or to some, or just to one?

This question is very complex from the family point of view, with delicate issues of harmony, proximity and personalities all factoring in.

Nevertheless, a decision must be made and settled in the parents’ Wills, or the whole matter becomes a ticking time-bomb for the children. In addition to these family concerns, there are different tax and financial consequences arising from the choice ultimately made by the parents. In some cases, the best decision is to leave the cottage to only one of the children. Perhaps only one child is interested in the cottage, or others have recreational properties of their own, or others are too geographically distant for cottage ownership to be practical.

If that decision is made, for whatever reason, there are still important considerations for the parents to ensure that the time bomb does not explode after their passing. The first is the tax consequences.

Perhaps the cottage is left to the son, and the remainder of the estate to the daughter. If so, then after the parents die, then the son will receive his cottage free and clear, while all of the Capital Gains Tax liability built up on the cottage will be paid from the daughter’s share! To avoid this unfair and unintended result, special planning is required with specific wording included in the Wills.

Another planning problem arises from the wish of the parents to be fair to all children. Most want to ensure that each child receives a roughly equal portion of the estate. Accordingly, if one child is to receive a valuable cottage, then this inheritance should be balanced in the Wills for the other children.

This balancing or adjusting mechanism can be one of several approaches. For example, it could be an arbitrary figure chosen by the parents and incorporated into the Wills. Alternatively, it could be at a fixed amount determined by a present value appraisal, which is specified in the Wills.

Another approach could be to set out an adjusting formula in the Wills, using an appraisal figure to be obtained as of the date of death of the parents. Each has its advantages and disadvantages, but don’t forget to provide in your planning for the possibility that your non-cottage assets may be substantially reduced from their present value by the time of your passing.

The dilemma of leaving the cottage to all, some, or one of the children is very complicated. It is vitally important to family harmony and to the successful transition of the cottage to the next generation to sort out the best balance of practicality and fairness.

A lawyer experienced in estate planning can be of great assistance in analyzing and advising as to the best method for your family.

Prior to 1992, every individual could take advantage of a Capital Gains Tax exemption of $100,000. This meant that if a husband and wife bought a cottage for $50,000 it could pass upon their death to their children without being taxed even if it had increased in value to $250,000.

After changes to the Income Tax Act in 1992 and 1995, the Capital Gains Tax exemptions were first cut back and then terminated. Now that same cottage passing to children could trigger over $75,000 in Capital Gains Taxes to be paid by the estate. In many cases, this huge cost may leave the children little choice but to sell the cottage to raise the cash necessary to pay the tax.

Many people elected to use special provisions of the 1995 budget to minimize this potential problem. If you were one of these fortunate and farsighted people, then you should seriously consider transferring the cottage to the children now. This will permit the cottage to reach the next generation with the least Capital Gains Tax consequences. It also means that payment of future Capital Gains Tax liability can be deferred for a generation (for the lifetime of your children).

If you do not wish to transfer the cottage to the children now, then you must give serious consideration to funding the Capital Gains Tax liability, through other assets or perhaps insurance.

What is certain is that Capital Gains Tax liability is one of the most serious obstacles to passing the cottage on to your children. The financial problem will only get worse as time goes by. One of the first steps parents should take in planning family cottage continuity is to obtain advice and make decisions to deal with this potentially disastrous problem.

1. What is the fair market value today?
2. Start by figuring out the present fair market value (FMV) of the cottage. Check recent sales in the area, ask a realtor for an opinion of value, or pay for an appraisal.
3. What is the cost base?
4. Find the cost base of the cottage. If you acquired the cottage after 1971, the value as of the date of acquisition is the cost base. If you acquired it before 1971, then the value as of December 31, 1971, is the relevant amount. If you cannot get this value by yourself, appraisers can research comparable sales.
5. How many capital improvements?
6. Next, add up the capital improvements made to the cottage or the property since you acquired it. This would include new docks or additions, replacing the roof or windows, installing a new well or pump. You can’t include simple repairs, maintenance or the value of your own hard work in improving the cottage, only the amount actually paid to others. Can’t find the invoices and receipts? At this stage, just write down as accurate and complete a list of improvements and costs as possible.
7. What is the adjusted cost base?
8. Now add the cost base and the capital improvements. This will produce the adjusted cost base (ACB). (If you were clever enough to make use of the capital gains tax exemption before it was taken away in 1994, then you can get the ACB from the tax return in 1994. The process above still applies, but from 1994 instead of from the date of acquisition.)
9. What is the total capital gain?
10. Subtract the Adjusted Cost Base from the Fair Market Value. This gives you the total capital gain.
11. What is the tax payable?
12. Divide the capital gain figure by half to get the taxable capital gain, then again by half to approximate the tax actually payable.

Sound complicated? Here’s an example:

1. The realtor estimates the fair market value today to be $550,000.
2. You bought it in 1979 for $50,000, this is your cost base.
3. You have spent $100,000 over the years on capital improvements such as water system and additions.
4. The Adjusted Cost Base then is $150,000 (cost base of $50,000 plus improvements of $100,000).
5. The total capital gain is $400,000 (FMV of $550,000 less ACB of $150,000).
6. The approximate tax payable if the cottage is transferred (including a gift or inheritance by children) will be $100,000 (half the total capital gain, then halved again to represent your marginal tax rate.

Once upon a time, there was no Capital Gains Tax in Canada. The federal government imposed it on an objecting populace as of January 1, 1972. Since then, the general trend has been from bad to worse as tax inclusion rates were increased, fairness was diminished and exemptions taken away. Recently we have seen a glimmer of light in the reduction of the inclusion rate to 50%, but this break could be reversed overnight.

One of the most valuable tax tools left to us when planning to keep the cottage in the family is the principal residence exemption. It is also one of the least understood. All Canadian residents qualify for this exemption. Basically, it says that our principal residence is not subject to capital gains tax no matter how much it increases in value. There are several techniques to use this to reduce the capital gains tax impact on a cottage. With knowledge about the principal residence exemption, you can stack the deck to deal yourself a winning hand. Here are three of the best techniques to beat the government at its own game.

1. Double or Nothing: In previous years, a husband and wife were each allowed to designate a residential property as a principal residence. This meant that the husband could exempt the house from capital gains tax, while the wife could use her exemption for the cottage. Unfortunately this advantage was taken away effective December 31, 1981. Since then, an individual or a married couple is limited to only one principal residence at a time. However, the benefit of the double exemption continues. If you and your spouse were clever enough to own the house and the cottage in separate names prior to 1982, you can take advantage of a double exemption for the period the properties were owned prior to that year. As much as a whole decade of capital gains exposure can be made to disappear with a wave of the pen. Not sure how title to the house and cottage were held during that period? A few dollars spent on a lawyer to sub search your property records will let you know whether you can get a double exemption.
2. Nothing Up My Sleeve: The fact that since December 31, 1981, only one principal residence exemption is available does not mean that cottage owners should ignore the advantages of this technique. You can designate the cottage as your principal residence rather than the house, if that works to your advantage. You do not need to pretend that your head hits the pillow more nights at the lake than in town. It’s your right to choose which of your residences you want to exempt. When would this work for you? Maybe you inherited the cottage in 1985 at a value of $50,000 and bought a house the same year for $100,000. Now, 15 years later, both properties are worth $200,000. The capital gain on the cottage is $150,000, while on the house it’s only $100,000. All other factors being equal, you would save as much as $11,750 in tax by designating the cottage as your principal residence.
3. Shuffling the Deck: Another good trick to know is that you can switch the designation of principal residence to best suit your tax reduction goals. It’s not uncommon for there to be periods when waterfront properties are skyrocketing while ordinary house prices are relatively stable, and then periods when the reverse is true. You can take advantage of this to save tax dollars. Let’s use an illustration. Bob’s city house doubled in value from 1980 to 1990. Both cottage and house prices were stagnant from 1990 to 1995. Then his cottage went up in value greatly from 1995 to 1998. Since then, the gain in value on the house exceeded that on the cottage. For tax reporting purposes, Bob should use his principal residence exemption on the cottage to exempt the big gain of 1995 to 1998, and use it on house for the big gains of 1980 to 1990 and 1998 to 2000. To make effective use of this technique will require several appraisals of both properties to support Bob’s choices. It may require research, but the technique is lawful, makes the maximum use of the exemption, and the payoff may be saving thousands of dollars in tax for hundreds of dollars in appraisal expense.

Designation timing: If you think the principal residence exemption may save you tax dollars, but are confused by the designation process, don’t be. You need not make decisions about the designation now, only when you “dispose” of a property for tax purposes. A disposition includes a sale to others, or a gift to children, or even passing a property through a will upon death. When you “dispose” of your cottage or house, you must decide whether to use the principal residence exemption, then file your tax return accordingly. To assist in your decision process, you should seek professional advice. Then you can be certain your tax reporting makes maximum use of the principal residence exemption to minimize the capital gains tax hit.

Dick Harrison’s fondest childhood memories center on the family cottage. His dad taught him to canoe and fish. His mom watched him swim and played cards with him on rainy days. He was lulled to sleep by the call of the loon and the lap of the waves. His first romance was with a girl down the lake. He loves the cottage and the special summers there.

Harrison inherited the cottage when his parents died. He hoped his three children would also enjoy the benefits of cottage life and to his delight, they took to it like ducks to water.

Now a grandfather, Harrison is determined to keep the cottage in the family for the next generation. But he fears this may leave his children and grandchildren a legacy of problems. Aware of succession problems (see the May, 2000, issue of Good Times magazine) including tax costs on death, children squabbling over operating costs, disputes over use and the threat of forced sale, he asked me for advice.

I gave Harrison the good news: selling is the last alternative, not the only one. I discussed with him the three principal challenges in planning for family cottage succession, then outlined a six-step plan to help it happen successfully.

Paying the Capital Gains Tax: The first challenge in changing the ownership of a cottage is the capital gains tax. This must be paid when the cottage is sold or transferred, during the parents’ lifetime or after their death. Although the federal government recently reduced the impact of this tax, it can still cost tens of thousands of dollars, and many families are forced to sell the cottage as a rest.

Keeping the cottage going: The second challenge is working out how the children will agree to use and operate the cottage. Among the questions to be answered are: Can any child use the cottage any time, or will there be periods of exclusive use? Who will open and close the cottage? Who makes sure the bills are paid? Who decides if improvements or additions are to be made? When a son dies, does his share of the cottage pass to his wife or his children, or does ownership continue with the surviving siblings only. Without good answers to these questions, many cottages become a source of family strife, not pleasure.

Managing expenses: The third challenge involves the children’s financial status. Usually siblings have different financial resources and abilities. Expenses are inevitable, whether it’s replacing the septic system, paying the municipal taxes or repairing the roof. If some of the kids can’t afford to contribute their fair share, then friction and stress are also inevitable.

The advice that follows gives you ideas on how each of these challenges can be dealt with. This information will help you make informed decisions, but once you’ve got a plan, it’s best to have it checked out by a professional who can make sure you haven’t overlooked any important considerations, financial and otherwise.

1) Estimate the Capital Gains Tax Before alternatives can be considered, the capital gains tax issue must be addressed, whether the cottage is gifted to the kids or sold to others at fair market value, either while the parents are alive or after their deaths. An accountant can do this for you, but you can also do it yourself. The worksheet that follows tells you how.

2) Reduce the tax bite 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.

Should you wish to transfer the cottage while you are alive, one valuable technique is to transfer it in stages, rather than all at once. If you transfer 20 per cent each year for five years, the capital gains taxes in each year will be much less.

If you’re considering a transfer during your lifetime, check the effect on your Old Age Security. The transfer of a cottage, even as a gift, results in your income tax return showing half the capital gains tax portion as income. If your income exceeds $52,800 (the amount for the 2000 tax year), the government starts clawing back the OAS. If your real income is $40,000 and you add $20,000 worth of capital gains income from the cottage transfer, the OAS clawback will be triggered.

This clawback of your monthly OAS can be avoided or minimized. Using the same example of real income and deemed income from the cottage transfer, if you transferred half the cottage this year and the other half in January of next year, the total income level would be below the threshold that triggers the clawback. Without careful planning, you may lose as much in OAS clawback as you pay in capital gains tax.

If you leave the cottage in your will, then the capital gains tax is deferred until you die. The actual amount paid may be greater, because the cottage fair market value may have increased, but the tax can be paid from a variety of sources, not from your present assets.

Whether you transfer the property during your lifetime or in your will, an excellent technique to reduce the capital gains tax is to use the principal residence exemption. Increases in value on a principal residence are exempt from capital gains.

Usually we think of our house as our principal residence, not the cottage. Legally, however, you can designate either for the purposes of the exemption. For example, if over the last 10 years, your cottage has increased in value more than your house, you can choose to designate the cottage as your principal residence for that period. You can only designate one property as a principal residence for each specified period, See the sidebar for clever techniques using this exemption to minimize the tax hit.

3) Fund the Capital Gains Tax Liability If you decide not to pass the cottage on to the kids during your lifetime, then it is important to identify funds to pay the tax so the cottage won’t have to be sold. An obvious source is the sale of your home. As a principal residence (unless you have designated the cottage as such), it is exempt from capital gains tax. Therefore all of the net proceeds from the sale of the house are available to pay the tax on the cottage.

Other sources of funds include savings and investments. If these are not sufficient, then get creative. Even elderly parents in reasonable health can qualify for more life insurance coverage. If the premiums are too high for the parents to comfortably manage, then consider asking the children to share the cost. Splitting the premium among several people may make this an affordable alternative.

Perhaps you’d like to pass the cottage to your children during your lifetime but can’t afford the tax, even if the transfer is spread over five years to minimize the annual impact. Consider asking the kids to share the annual tax consequences. If, each year, the parents transfer 20 per cent of the cottage to their four children, and each transfer triggers $20,000 of gain, then each child would have to pay no more than $1,200 annually. This may be a small price to pay to know that they will eventually acquire the cottage and not have to deal with a much larger tax amount in a single year.

Another possibility, although not always practical or desirable, is to use the cottage value itself to fund the tax cost. If you have a large parcel of land, you may be able to sever a lot and sell it. And if there isn’t enough cash after the death of the parents, the kids could put a mortgage on the cottage and pay that off over 5 or 10 years.

4) Select your preferred plan Now that you know what the capital gains implications are and have some ideas on how this can be funded, you’re reading to formulate a plan to transfer ownership of the cottage. There are a variety of options, including:

• Gifting the cottage to the children now. Gifting is simply transferring an interest in the cottage without requiring payment. It uses the same deed form, but no value of consideration is specified because no money is involved. You cannot save on taxes by gifting. For tax purposes, the property is deemed to pass at fair market value. You must report the gift transfer on your next income tax return as a taxable disposition using the fair market value (FMV), even though you actually received no money. This is one of the impediments to cottage succession – even though the parent may choose to give the cottage away, the tax costs are the same as a real sale, and the parent does not have sale proceeds to pay the tax.
• Selling the cottage to the children at market value or less now. Even if you sell the cottage to your children for less than market value, you still must report the sale at FMV for tax purposes.
• Transferring to the children a percentage of the cottage in stages over several years, whether by gifting or selling. Regardless, that portion will still trigger capital gains tax if there was a gain. If the total capital gain on a cottage is $50,000 and you gift 10% to a child one year, then you have triggered 10% of the total capital gain in that year and must report $5,000 on your tax return.
• Retaining a life interest for parents, whether gifted or sold. If a parent gifts the property, he or she just retains the life interest by saying so on the deed of transfer. If the children are buying the cottage, then they must either agree to the life interest or the sale will not take place. The life interest provides several advantages to the parents. One is that it entitles them to use the cottage for their lifetime as of right, not rely upon the continued goodwill of the child who now owns the cottage. Another is for the parents to retain a measure of control. With a life interest, the child cannot “cash in” on the cottage by selling it or mortgaging it, without the involvement and consent of the parents. This would defeat the intention of keeping the cottage for family purposes. If and when the parents are no longer interested in using the cottage, or are no longer concerned that a child may cash in on it, then the life interest can be released. This is done by a simple and inexpensive registration on the title of the cottage.
• Leaving the cottage to the children in your will.

Each of these options (there are more) will have advantages and disadvantages as to amount and timing of tax liability, loss or retention of control, exposure to claims by divorcing in-laws and other consequences. At this stage, it is almost certainly best to involve professional advisers such as a lawyer and/or accountant to properly weigh the benefits, accurately predict the costs, and avoid unpleasant surprises.

5) Agreements avoid adversity Once you have decided on a plan, your task is not over. Cottages that survive the shoals of succession to safely reach the next generation now must run the dangerous rapids of family dynamics. These can be even more complicated and less predictable than tax rules.

While parents are alive, they may make most of the cottage decisions. From habit and respect, children generally follow their parents’ lead. What happens after the parents are no longer involved?

Maybe your children always agree, but most families will run into serious difficulties among themselves sooner or later. Some of the issues will be mundane, others will be major. All these considerations have the potential to create friction:

• Who will open and close the cottage?
• Should the ongoing costs of the cottage be shared in proportion to usage by kids, or split evenly?
• Who decides if improvements or additions will proceed?
• Who is responsible for making sure the utility bills, municipal taxes and insurance premiums are paid on time?
• Can all children use the cottage all the time, or will there be periods of exclusive usage for each child? Who decides those periods?
• Can children bring friends as guests, or will it be family members only?
• Can a child rent the cottage during his or her turn, if he or she cannot use the cottage personally?
• Can a child in need of money force the others to buy his or her share? Can a child sell the share to a third party without the consent of the other siblings?
• What happens if a child/owner dies? Does the share go to the surviving spouse, who may later remarry?

These are serious issues, and many family cottages only survive a few years before the accumulated stress turns the cottage into such a bone of contention that it is listed for sale.

The solution is a written Cottage Co-Ownership Agreement. You can create this as a family, or prepare one with a lawyer. As a written contract, the agreement should be legally enforceable. The details should be worked out before the children take over. The parents can serve a leading role in encouraging the creation of this cottage saving device, and in facilitating compromises. Some matters may be dealt with by a simple majority. This would work well for decisions such as redecoration or usage. Others may require unanimous approval, such as additions to the cottage or a sale to non-family members.

With an agreement, most issues can be resolved before they become problems. Although every child may not be happy with the outcome, he or she should accept the result because all agreed beforehand on the method of resolution.

A Co-Ownership Agreement is essentially a business partnership agreement. Some issues addressed are identical, like decision-making procedures and disposition of interests by the partners. Other matters are unique to cottages and your own family’s needs and desires. You can try to work it out yourselves, or you may decide that involving a lawyer will increase the chances of a thoroughly protective document.

One way or the other, a Co-Ownership Agreement is the best insurance policy against loss of family harmony and the cottage itself. If it’s left for the kids to work out after the parents have died, it may never be accomplished.

6) Level the financial playing field In every family, there will be differences in incomes and wealth among the children. Some kids will be struggling with mortgages and grandchildren’s educational costs, some will have a nice nest egg already set aside.

What happens if one of the cottage co-owners cannot come up with his or her share of the taxes, the insurance, or the cost of replacing the septic system? Do the septic repairs wait a few months or years until all can contribute equally? Do the more affluent carry the burden for the less fortunate?

There is an excellent solution. Parents can set money aside in their wills for a Cottage Trust. This money is invested and administered by the executor child or children, and is reserved for cottage uses only. The investment income can be used to contribute towards the annual carrying costs of taxes, insurance and electricity. This contribution reduces the amount that each child has to dig out of his or her pocket each year.

When a major problem arises, like replacing that pesky septic system, the Cottage Trust again comes to the rescue. If one or more of the children cannot come up with an equal share of the cost, then the repair is paid out of the capital of the trust. True, this leaves less money next year to produce income, so each kid will have to dig a little deeper to come up with the portion of the carrying costs. However, conjuring the thousands of dollars required for the septic system may be impossible, while finding a few hundred for annual costs may be merely inconvenient.

Safe and sound You can choose the succession plan that best suits your family situation, work with your children on a Co-Ownership Agreement that anticipates, avoids or resolves inevitable issues. Then you can sit back, like Dick Harrison on his deck chair, and admire the splendid scenery, secure in the knowledge your family will enjoy the same lovely view for generations to come.

This article will help you plan for family cottage succession. It is not a substitute for professional advice.

A         JOINT PARTNER TRUST

Assets that pass through a probated Will are subject to Estate Administration Tax (often referred to as “probate tax”).  This tax is slightly less than 1.5% of the value of the probated assets, and so on a $750,000 estate the Estate Administration Tax would be about $11,000 in Ontario.

This tax can be avoided entirely or substantially reduced if another succession vehicle is utilized, called a Joint Partner Trust (JPT).  Your cottage (and non-registered investment assets and city residence if desired) are transferred by you into this trust, and Canadian residents over age 65 may settle such assets upon the trust without triggering capital gains tax.  No Land Transfer Tax is paid when the cottage is transferred into the JPT.

The trust assets are controlled solely by you during your lifetime (unless or until you choose to involve the assistance of others, typically your children), and the capital and income can only be for your benefit during your lifetime. 

• During the lifetime of the spouses, typically both spouses will share the responsibility and control as trustees.
• Upon the death of the first spouse, the surviving spouse continues as sole trustee unless he or she prefers to “promote” another (usually one of the children) to be a co-trustee to assist and provide greater protection.
• Upon the death of both spouse, the substitute trustees (usually one or more of the children) step into the trustee role; the assets then flow through the trust to your beneficiaries, and into protective and tax effective sprinkling inheritance trusts referred to in more detail below. 

The JPT does not cost or save you capital gains or income tax during your lifetime, but does provides the following important benefits:

• Retention of individual control of the cottage (and other financial assets) during your joint lifetimes.
• No capital gains tax triggered upon settling the cottage (or house and financial assets) into the trust.
• Option to involve a child as a co-trustee upon the death of the first spouse if desired to help the surviving spouse and protect against risks such as scams or predatory second marriages
• Avoidance/reduction of probate tax upon death. 
• Quicker, easier and less onerous estate administration following your death.

While the Joint Partner Trust provides many benefits for general estate succession purposes, it is particularly attractive as a vehicle to pass cottage ownership on to the next generation.  Once the parents have determined which of their children are to be the stewards of the family cottage, and once the children have proven that they can be entrusted with shared cottage ownership by developing and signing a Cottage Sharing Agreement, then the parents can safely create the JPT and transfer at least the cottage into it.  This will deliver the advantages of continued control and probate tax avoidance outlined above, but significant other benefits. 

• Their principal residence exemption will still be available to exempt the cottage from a period of capital gains if the parents choose to sell their city home and move into an apartment or seniors residence. 
• And with ownership of the cottage held within the trust, should a widow or widower remarry after the death of the first spouse, the cottage will not be at risk of family law claims on a subsequent separation or divorce or of being inherited by the new spouse’s family following the death of the surviving spouse.

B         SPRINKLING INHERITANCE TRUST

A “sprinkling” inheritance trust (SIT) is a method for beneficiaries to inherit that provides very significant potential benefits.  Typically your named beneficiary him or herself would be the trustee, and so in full control of all of the inherited assets.  Only your named beneficiary can decide whether the inheritance assets should be retained, or spent, or re-invested.  He or she can also decide how the income generated from the inheritance can be taxed.  If his or her spouse was at a lower marginal tax rate than your child, he or she could choose to have the income generated from the invested inheritance taxed at that lower rate.  Similarly your child could choose to assist his or her own children financially from the income, and again that income would be taxed at the grandchild’s own much lower or non-existent marginal rate.

Your beneficiary and his or her children and grandchildren are all designated as potential beneficiaries of the cottage.  For up to 21 years after the death of the parents, the children beneficiaries will control the cottage as trustees of the SIT. 

Among other benefits, the SIT is a very effective asset protection trust.  If your beneficiary went bankrupt or had creditor problems, the trust assets would be exempt from claims. 

If a married beneficiary was sued for divorce, the trust assets are also exempt.  This is true even if the beneficiary child owns an interest in the cottage.  Normally by operation of the Family Law Act the cottage would be considered to be a “matrimonial home” and so subject to claims by a divorcing in-law.  However if the beneficiary child retains his or her cottage interest in the SIT, then the Ontario Court of Appeal has ruled that the cottage does not become a matrimonial home and so is exempt from divorce claims.

At or before 21 years after the death of the parents, the beneficiary children can choose to transfer ownership of the cottage out of the SIT to him or herself personally, or to his or her children if preferred.  There is no capital gains tax paid at the time that the cottage transfers out of the SIT to the children or grandchildren personally, even though its value may have doubled or tripled over the 21 years.

A sprinkling inheritance trust is of special importance to parents who are passing ownership of a family cottage to children, either by way of their Wills or a Joint Partner Trust. 

• The assurance that the cottage will not qualify as a “matrimonial home” upon a child facing separation or divorce is greatly comforting, since the Courts have held that there can be more than one “matrimonial home”.  This means that a divorcing child will face not only the division of his or her interest in their own house, but also a claim against the value of his or her interest in the family cottage – unless that cottage interest is held in a sprinkling inheritance trust! 
• It also provides potentially significant capital gains tax advantages.  Although the cottage will be capital gains tax paid at the time it is inherited by the children, it will increase substantially in value every year afterwards.  If the child wants to take personal ownership of the cottage and avoid paying the accumulated tax, all he or she needs to do is to transfer the cottage out of the trust and into his or her name prior to the expiry of 21 years after the death of the parent.  Even if the cottage has doubled or tripled in value since the time of inheritance, no capital gains tax is payable at that time, and does not have to be paid until the child chooses to pass on ownership to his or her own children, or upon his or her death. 
• But the opportunity for an even greater period of capital gains tax deferral is provided by the sprinkling inheritance trust, called “generation skipping”.  As the 21 year expiry period approaches the child could choose, instead of transferring ownership to him or herself personally, to instead transfer ownership to his or her own children.  Again no capital gains tax would be payable at the time of that transfer, but now the payment of the tax is deferred not just for the duration of the child’s lifetime but instead for so long as the grandchildren might live.