How to Preserve a Family Cottage With Life Insurance

Keep your cottage for generations to come by learning how life insurance can help mitigate capital gains taxes.

10 minute read
Originally published: February 16, 2024

How to Preserve a Family Cottage With Life Insurance

How to Preserve a Family Cottage With Life Insurance

Keep your cottage for generations to come by learning how life insurance can help mitigate capital gains taxes.

10 minute read
Originally published: February 16, 2024

How to Preserve a Family Cottage With Life Insurance

In the heart of Canada’s breathtaking landscapes, the family cottage stands as a reminder of cherished memories deeply intertwined with the natural beauty of its surroundings. Despite representing such emotional wealth, passing down a family cottage can come with many challenges, chief among them is the potential financial burden imposed onto heirs through capital gains tax. This tax, levied on the increase in value of the cottage from its original purchase price to its current market value, can significantly diminish the estate’s value intended for beneficiaries. It’s a scenario that many families must navigate carefully, in order to ensure that the legacy of their cherished retreat can continue without causing undue financial stress.

This guide will delve into the realm of life insurance as a useful tool for addressing these challenges and offer seamless solutions to the complex issues that can arise when inheriting a cottage. Our goal is to provide you with the insights and knowledge needed to make informed decisions about your financial future. Whether you’re looking to safeguard your family’s legacy, minimize financial burdens on your heirs, or simply understand the options available, this guide is your compass through the complexities of preserving a family cottage with life insurance.

Understanding Capital Gains Tax on Family Cottages

Capital gains tax is a critical aspect of Canadian tax law that directly impacts the inheritance and transfer of family cottages. When a cottage, cherished by generations for its emotional value and memories, appreciates in monetary value from the time of its purchase it can be a trigger for capital gains tax upon its transfer to heirs.

What Triggers Capital Gains Tax?

Capital gains tax is triggered when the cottage is sold or deemed to have been sold, such as when it’s transferred to heirs upon the owner’s death. The tax is applied to the difference between the property’s acquisition cost and its selling price or fair market value at the time of transfer. In essence, if a family cottage was purchased for $200,000 and is valued at $800,000 at the time of the owner’s passing, the $600,000 increase represents a capital gain, of which a portion is taxable.

How Does Capital Gains Tax Affect Cottage Inheritance?

The financial implications of capital gains tax on cottage inheritance can be significant. Canada’s tax system only taxes 50% of the realized capital gains at the individual’s marginal tax rate. However, this could still result in a substantial tax bill that the heirs must address, potentially forcing them to sell the cottage if sufficient liquidity is not available to cover the tax liability. This situation places the cherished family retreat at risk of being lost from the family due to financial constraints.

Calculating Capital Gains Tax

To calculate the capital gains tax, it’s essential to determine the adjusted cost base (ACB) of the cottage, which includes the purchase price plus any capital improvements made over the years. The difference between the cottage’s fair market value at the time of transfer and its ACB represents the capital gain, half of which is subject to tax at the owner’s or the estate’s marginal tax rate.

The Financial Implications for Heirs

The financial implications of inheriting a family cottage can vary significantly depending on the cottage’s appreciated value and the existing tax laws. It is crucial to plan for this tax liability when estate planning to ensure that the cottage can transfer ownership as intended. Without proper planning, heirs may have to face difficult decisions, such as the potential sale of the cottage in order to satisfy tax liabilities.

Strategies to Mitigate Capital Gains Tax

Several strategies can be employed to mitigate the impact of capital gains tax on the inheritance of a family cottage. These include but are not limited to: 

  • Using a life insurance policy with enough coverage that it can cover the anticipated tax bill with the death benefit.
  • Gifting the cottage to heirs during your lifetime to avoid complications that come with transfer of ownership after your death.
  • For a cottage that is considered your principal residence, utilizing the principal residence exemption to make the transfer or sale of the property tax exempt.

Case Study

Robert has owned a cottage for many years that he and his family often visit during the warmer months to spend time by the lake. He originally purchased the cottage for $200,000 and there has been $50,000 of capital improvements since he purchased it. If Robert were to pass away today, the fair market value of the cottage at the time of transfer would be $800,000.

To calculate what the capital gains tax would be Robert should consider the following:

  • The Adjusted Cost Base (ACB) includes the original purchase price plus any capital improvements. In Roberts case, the ACB would therefore be $200,000 + $50,000 = $250,000.
  • The capital gain is the difference between the fair market value at the time of transfer and the ACB. In Roberts case the capital gain would therefore be $800,000 – $250,000 = $550,000.
  • The taxable capital gain in Canada is 50% of the capital gain. For Robert, the taxable capital gain would therefore be %50 of $550,000 which is $275,000.
  • The tax liability is calculated by applying the marginal tax rate to the taxable capital gain. For Robert who is in a tax bracket of 53.53% the tax owed would be $275,000 × 53.53% = $147,207.50.

This means that Roberts heirs would face a $147,207.50 tax liability which may be a financial burden they are not ready for. Here is a quick reference for the calculation Robert used:

Case Study Cottages

To mitigate the capital gains tax that his family would face, Robert has three potential options:

  1. Robert could purchase life insurance with around $150,000 in coverage (or more depending on his other financial needs). By purchasing a life insurance plan with enough coverage to cover the tax liability of the family cottage, the death benefit payout to his beneficiaries would allow the property to be passed on without the capital gains tax becoming a burden on his heirs.
  2. Robert could also consider gifting his estate to his heirs at a more advantageous time while he is still alive. This can prevent the capital gains tax from rising in the upcoming years of Robert’s life and ensure that his heirs will never inherit the cottage when they are not financially able to do so.
  3. If Robert had designated the cottage as his principal residence, he may be able to apply for the principal residence exemption. By leveraging this exemption he could eliminate or reduce the capital gains tax, depending on how many years the cottage was designated as the principal residence.

Robert considers his options and decides to purchase a life insurance policy with $200,000 in coverage. This policy will mitigate the capital gains taxes of the family cottage while also allowing Robert to keep ownership of the cottage for the remainder of his life. The extra $50,000 in coverage can offer his family some extra money to help with other end-of-life expenses but also ensure that if the capital gains taxes were ever to rise due to increase in property value or any future capital improvements there will still be enough to cover the capital gains tax.

Joint Last-to-die Life Insurance Policies Explained

Joint last-to-die insurance policies represent a strategic and cost-effective way to address estate taxes and capital gains associated with family cottages. These policies are especially advantageous for couples as they offer life insurance that is particularly useful in preserving assets like family cottages for future generations.

Joint last-to-die policies work by insuring two lives under one policy. These policies are typically purchased by spouses and pay out the death benefit upon the death of the second insured individual. This means that as the second insured individual passes and estate taxes and capital gains taxes are likely to impact heirs, a death benefit will be paid out to the designated beneficiaries.

Benefits of Joint Last-to-die Policies

There are many benefits to joint-last-to-die policies when planning on passing down a property such as a family cottage. Joint-last-to-die policies are cost effective with more flexibility and control over planning estate taxes and cash flow. Here is an overview of the benefits of joint-last-to-die life insurance policies:

Benefits of Joint Last-to-die Policies

Individual Life Insurance Policies

Another option available to owners of a family cottage are standalone permanent life insurance policies. These include Term 100, Whole Life, and Universal Life insurance options, each offering unique benefits tailored to individual estate planning needs, including addressing capital gains tax liabilities on family cottages. Owners of a cottage might choose an individual life insurance policy if they intend to directly pass it down to an heir after their death in circumstances where they don’t have a spouse they would like to pass it to first.

Term 100 Insurance

Term 100 insurance presents a straightforward permanent coverage solution. It guarantees permanent life insurance coverage for the rest of the policyholder’s life with level premium payments that stop once the policyholder reaches 100 years of age. This policy type has lower premiums than other permanent life insurance options as it does not come with a cash value component. This makes it a cost effective choice for those solely interested in providing a death benefit to cover fixed liabilities, such as capital gains taxes on a family cottage.

Whole Life Insurance

Whole life insurance stands out by offering both lifetime coverage and the potential for wealth accumulation through the cash value of the policy. This policy type comes with fixed premiums and offers permanent coverage for the rest of the policyholder’s life and provides both a death benefit and a cash value component that grows at a guaranteed rate. It’s available in participating and non-participating forms, with the former possibly earning dividends in addition to the cash value.

Universal Life Insurance

Universal life combines protective coverage with investment opportunities. Similar to whole life insurance, this type of insurance offers fixed premiums and offers permanent coverage and provides both a death benefit and a cash value component. However, universal life insurance gives policyholders more control over the cash value and investments associated with their policy making it a great option for those interested in investment and growing their wealth.

Frequently Asked Questions (FAQs) About Preserving Your Family Cottage With Life Insurance

Unless your cottage is designated as your principal residence capital gains taxes will still be applied when the property is transferred or sold. If you want to avoid capital gains tax on your family cottage, you may want to gift the cottage to your heir before you pass away in order to avoid an increase in capital gains tax and ensure your heir can afford to take over ownership. However, one of the more popular ways to mitigate the capital gains tax is to purchase a life insurance policy with enough coverage to cover the cost of the tax liability after you pass. This ensures that the payout of the death benefit aligns with the transfer of ownership to offer a cash influx to your heir that covers the cost of the capital gains taxes.

If you would like to minimize the capital gain taxes that are triggered by the transfer or sale of your cottage, you should consider what expenses you can deduct from your claim to help minimize the tax liability. Some some common deductions you can claim include the purchase price of the property and all related costs including any legal fees used on closing, home inspection cost, land transfer tax, costs to set up utilities, title insurance, as well as capital improvement you’ve made to the cottage over the years including any structural changes or new additions to the property. Be sure that you keep all documentation and receipts that demonstrate these costs so that when your cottage transfers ownership the capital gains taxes can be properly calculated.

If you aren’t interested in life insurance and want to avoid burdening your heir with tax liabilities they may not be able to afford after you pass, you may consider gifting your cottage to your heir while you are still alive. This allows you to select a more advantageous time to transfer ownership when you can ensure that the capital gains tax is something your heir can afford. This can also prevent the capital gains tax from rising in the upcoming years of your life and ensure that your heir will never inherit the cottage when they are not financially able to do so.

Ensure Your Cottage Will Stay in Your Family

The decision to implement life insurance into your estate planning is a pivotal step towards preserving your family’s legacy. However, the intricacies of each policy, combined with the specific dynamics of your estate, emphasize the importance of getting personalized advice. Consulting with knowledgeable financial advisors who can offer expert advice about life insurance and estate planning will ensure that you find the best plan for your unique circumstances.

At Protect Your Wealth, we work with and compare policies and quotes from the best life insurance companies in Canada to ensure the best solution for you and your needs. We provide expert life insurance solutions, including no medical life insurance, critical illness insurance, term life insurance, and permanent life insurance to help you get the protection you need. Schedule a consultation about your financial goals and needs by contacting Protect Your Wealth or call us at 1-877-654-6119 to talk to an advisor today! We’re proudly based out of Hamilton, and service clients anywhere in Ontario, British Columbia, and Alberta, including areas such as Aurora, Calgary, and Burnaby.

Speak to an expert advisor today!

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