Keeping the Cottage and Investment Properties in the Family

Real estate investors and families with a cottage often times want to pass down the asset to their kids as a way to help the next generation with an income producing asset or to keep the memories at the cottage for generations to come.

However, without proper planning your estate could end up having to sell the investment property or cottage to pay the final tax bill which could be sizeable if you have several investment properties or have owned your cottage for a long time.

With that tax bill there is a big need for liquidity and one of the most cost-effective methods for providing liquidity is with participating whole life insurance.

In addition to the death benefit payout there is a cash value component to the policy where you can access the cash values so you don't feel like your wasting money inside the policy. I have previous written an article more about that here.

In some instances if you have multiple children and one of them doesn't want the property, you can do an estate equalization where a life insurance policy can offer a fair equivalent to the property that will go to the other sibling, for more information about estate equalization click here

Keeping the cottage in the family example

• John owns a cottage in Ontario that has been in the family for 30 years. The cottage was purchased for $200,000 and is now worth $1,000,000. John wants to leave the cottage to his two children, Emma and Michael, in his will. He also owns a home in the city that is considered his principal residence, so the cottage is not eligible for the principal residence exemption.

Capital Gains Calculation:

1. Original Purchase Price (Adjusted Cost Base): $200,000
2. Fair Market Value at John's Death: $1,000,000
3. Capital Gain: $1,000,000 - $200,000 = $800,000

In Canada, 50% of the capital gain is taxable.

1. Taxable Capital Gain: 50% of $800,000 = $400,000
2. Assumed Marginal Tax Rate: 50%
3. Capital Gains Tax Owed: 50% of $400,000 = $200,000

Using Life Insurance to Cover the Capital Gains Tax:

To ensure that Emma and Michael can afford to keep the cottage without needing to sell it to pay the capital gains tax, John purchases a life insurance policy:

• Life Insurance Policy: John buys a permanent life insurance policy with a death benefit of $200,000 (the estimated tax liability).
• Beneficiaries: The beneficiaries of the policy are Emma and Michael, or the estate (which will then distribute the proceeds to cover the tax).

Outcome:

Emma and Michael pay the capital gains tax and inherit the cottage free and clear to enjoy for many years to come.

Keeping the investment property in the family example

• John owns a rental property in Toronto that he purchased 20 years ago for $300,000. The property is now worth $1,200,000 and the property has an outstanding mortgage balance of $300,000.

Capital Gains Calculation:

1. Original Purchase Price (Adjusted Cost Base): $300,000
2. Fair Market Value at John's Death: $1,200,000
3. Capital Gain: $1,200,000 - $300,000 = $900,000

In Canada, 50% of the capital gain is taxable.

1. Taxable Capital Gain: 50% of $900,000 = $450,000
2. Assumed Marginal Tax Rate: 50%
3. Capital Gains Tax Owed: 50% of $450,000 = $225,000

Total Financial Obligation for Heirs:

• Capital Gains Tax: $225,000
• Outstanding Mortgage: $300,000
• Total: $525,000

Using Life Insurance to Cover Both the Capital Gains Tax and the Mortgage:

To ensure that Emma and Michael can keep the investment property without needing to sell it to pay the capital gains tax and the mortgage, John purchases a life insurance policy:

• Life Insurance Policy: John buys a permanent life insurance policy with a death benefit of $525,000 (the combined amount of the estimated tax liability and the outstanding mortgage).
• Beneficiaries: The beneficiaries of the policy are Emma and Michael, or the estate (which will then distribute the proceeds to cover the tax and mortgage).

Outcome:

Emma and Michael inherit the rental property free and clear of the mortgage, and without the burden of a significant tax bill. They can continue to generate rental income from the property, and it remains within the family.

Estate planning is important for real estate investors and cottage owners because it organizes your assets and brings to light any potential tax implications for the estate. It's best to speak with a lawyer and insurance advisor knowledgeable in real estate to structure your plan correctly.

I have great Wills and Estate lawyers in my network that I would be happy to refer you to create or update your will and please reach out to me with any insurance needs you may have.