When cottage succession plans unravel, life insurance fills the gap

There are several challenges involved in keeping the family cottage within the family as it passes on to the next generation. A common predicament occurs when one or more children no longer live near the cottage.

Not everyone wants the cottage  

If advance discussions have occurred to determine that not all children want to inherit a family cottage, the next step is to sort out how to balance the estate distribution in a fair and equitable manner. Determining if there will be a disparity between the projected estate residue and the value of the cottage is critical.

The hypothetical scenario below outlines why comprehensive financial planning is particularly important in these circumstances.

Meet Jack and Loraine  

Jack, 66, and Loraine, 64, have three children: Tim, James and Joan. Jack and Loraine love their lakefront cottage that Jack inherited many years ago from his parents. Tim is the only child that uses his parents’ cottage on a regular basis, often joined by his family. James and Joan simply live too far away and are too busy with their own young families. Jack and Loraine are retired and in the process of updating their wills, which currently state that everything is to be distributed to their children in equal shares. Upon encouragement from their advisor, they recently discussed estate expectations with their children and if they were interested in inheriting the cottage.

Based on those discussions, they determined that only Tim is interested in owning the cottage in the future. Jim and Joan said they are good with whatever their parents decide but mentioned they would be content with inheritances of equal value. The parents want to keep the cottage in their own names until they pass, and they aren’t interested in selling it to Tim during their lifetime.

1. Projecting their estate value 

Jack and Loraine worked with their financial advisor to come up with estate projections based on an optimized retirement income plan. Their advisor calculated that the value of their cottage would be approximately $1.5M by life expectancy based on conservative growth estimates. Their remaining assets are projected to have a value of $3.3M by life expectancy. On the surface, everything looks okay.

2. Estimating estate taxes 

The projected $3.3M value is comprised of a $600K Registered Retirement Income Fund (RRIF), their principal residence worth $1.9M and $800K in non-registered investments (moderate-conservative risk profile). While assets can be rolled over to a surviving spouse on a tax-deferred basis, they cannot be rolled over to the children without tax implications. From CRA’s standpoint, it’s as if the parents sell all their assets at fair market value upon passing. In this scenario, there will be estate tax implications on each of the following assets:

• the family cottage
• the RRIF 
•  the non-registered assets

Their principal residence exemption will be applied against the deemed capital gain on their home. While it would be possible to apply this exemption against the cottage, the gain on the home will be significantly larger.

The terminal tax liability projects as follows: 

• $500K taxable gain (50% inclusion rate x $1M unsheltered capital gain on cottage)

• $100K taxable gain (50% inclusion rate x $200K capital gain on non-registered assets)

• $600K taxable income (100% inclusion rate x $600K RRIF)

The result is $1.2M of taxable income in the terminal return. At 50% tax rates, that’s a tax liability of roughly $600K, which is payable by the estate.

3. Inheritance disparity

After probate, professional fees and costs associated with the sale of their home, there is expected to be $2.6M in estate residue to be split by James and Joan, or $1.3M each.

In other words, Tim’s expected inheritance value of $1.5M (the family cottage) is greater than his siblings by $400K in total. The disparity could increase even more depending on several factors such as lifetime gifts to grandchildren, market fluctuations, charitable giving etc. Things could get tricky depending on how the will is worded and each child’s expectation for rectification.

4. Worst case future outcome 

Tim doesn’t have an extra $400K to equalize the inheritance and he’s not keen on taking out an additional mortgage to top up his siblings, so they decide to sell the cottage to accommodate an equitable outcome. The cottage is also overdue for some costly repairs. Tim is unhappy with this outcome and the sale ultimately severs his relationship with his siblings, as he blames them for forcing the sale of the cherished family cottage.

5. What can Jack and Loraine do to avoid this outcome? 

To ensure Tim can keep the cottage and an equitable estate distribution takes place, Jack and Loraine could shift a portion of their non-registered portfolio to a joint last-to-die permanent life insurance policy to cover the projected estate tax liability. This will not impose on their retirement flexibility while providing an equitable estate distribution. Benefits include: 

• Tax efficiencies during retirement as investments grow tax-sheltered within the policy (if they choose to invest within the insurance vehicle). 
• Jack and Loraine will likely reduce Old Age Security (OAS) claw back, as their non-registered investments generate proportionally less interest income on an annual basis (i.e., tax composition is improved as interest income is taxed unfavourably in a non-registered environment).
• More flexibility in retirement planning as direct beneficiaries can be named via the life insurance policy, which results in additional probate savings and potential executor fee savings.
• Liquidity will be available when required upon passing to pay the estate tax liability and provide adequate funds to ensure all beneficiaries’ goals are met. Downside market risk is removed from the equation.
• A tax-efficient source of capital may also be available later in retirement as the investment component of the policy can be leveraged without tax implications.

There may be other alternatives to explore, but the options will vary greatly depending on the specific facts of the scenario.

Quick summary  

While it’s always a good idea to ensure the estate tax liability, it’s important to note that certain circumstances create an even greater need. The family cottage is typically one of the most unique assets a family can own. Oftentimes, it’s a priority that this asset remains in the family, but if the children are scattered geographically, it’s unlikely they’ll want to inherit the property if given an alternative option.

Understanding the next generation’s level of interest and planning for a fair outcome can help preserve both family unity and the legacy of the cottage.