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For many families, it is much more important to preserve the family cottage than any other asset. Those who want to leave the cottage to their children must plan for tax consequences and disputes which may arise upon their death.

Tax liability at the time of death

The first hurdle to overcome when leaving an asset to your children is to make sure there are sufficient funds in your estate to pay any tax liability that may arise at the time your death. Many individuals do not realize that the increase in value of their vacation property since the time it was purchased may result in a tax liability for their estate. This is because upon death, there is a “deemed disposition” of all of a person’s assets, unless the assets are transferred to your spouse or common-law partner. A deemed disposition means that all of your assets are deemed to be disposed of for their fair market value. Therefore, upon death of the last spouse, there will be tax owing before the assets can be transferred to the next generation. The danger in failing to do estate planning is that you may need to sell some of the estate’s assets (including the vacation property) in order to pay the tax.

Principal residence exemption

One possible way to reduce the tax liability is to designate the property as your principal residence for tax purposes. And thus exempt some or all of the capital gains on the disposition of the property from taxation. However, families can only designate one residence as their principal residence for any given year. If you have owned more than one personal-use property during the same period of time, then the calculation of the principal residence exemption can become quite complicated. For example, if you have owned the family cottage for the last 20 years, but during that same 20 years you have bought and sold several “city homes” and exempted the gains on the sale of these city homes, you will not be able to shelter the entire gain on your cottage.

You do not have to designate a property as your principal residence until you actually sell the property or you are deemed to have sold it ( as you would in the year of death). At that point in time, you or your executor should speak with your financial and tax advisors to determine how to use the principal residence exemption to your best advantage.