No holiday from taxes
Now that summer is a distant memory and winter is coming, many owners of recreational properties are considering a sale or transfer to the next generation, either now in the fall, or next spring before vacation season heats up again. If you’re in this boat, you’ll need to do some tax planning because a sale of the recreational property or transfer within the family can result in a big tax bill.
Covering capital gains
It’s true that you can potentially “cover” your capital gains tax exposure on a cottage or vacation home by claiming the principal residence exemption. However, in order to be eligible for the exemption, the property must be ordinarily inhabited by you, your spouse, or your children. If the cottage is purely meant to be an investment property, to be rented out throughout the year, the principal residence exemption cannot be claimed.
But remember that the exemption is claimed on a year-by-year basis, so that if the cottage is used for personal purposes in any one year, you may be able to apply the exemption for that particular year. However, using the exemption against the cottage could leave your (real) primary residence eventually exposed to capital gains tax because there is a “one-principal-residence-per-family” rule under the exemption.
So it may be imprudent to use up the exemption on your cottage, especially since the appreciation on a primary residence is usually higher than the cottage.
If there has been no appreciation in your second home, you have nothing to worry about. That’s because capital gains tax on a sale or other transfer of the second home is calculated in accordance with the normal rules – that is, your cost base plus selling costs are netted from proceeds of disposition to come up with the capital gain. And if you have put improvements into the second home (e.g., renovations and the like), this should increase your cost base. However, the Canada Revenue Agency’s (CRA) position is that interest charges cannot normally be used to reduce capital gains exposure.
In order to substantiate such increases in your cost base, it is a good idea to maintain a file and include receipts for all eligible costs. This could include such things as improvements to plumbing, a new roof, and so on. If the home is outside the country, bear in mind that capital gains tax is measured in Canadian dollars, rather than the currency in which the home is situated.
One of the most dangerous tax traps involves a transfer your cottage within the family. In many cases, you may want to do this for estate planning or other reasons. However, if you transfer or gift a capital asset – be it a cottage or otherwise – to a family member other than your spouse, there is a “deemed sale” of the property at its current market value at the time of transfer.
You should assume a tax rate on capital gains of about 26% of the appreciation in value of the property (assuming the top marginal tax rate in Ontario). If this gain is taxed when the cottage passes to the next generation, one common approach is to buy life insurance to fund this extra tax bill. Insurance agents will, of course, be more than happy to sell you a policy.
However, there are ways to reduce or even escape this tax bill. One key strategy may be to put the cottage in the name of a child when it is purchased. That way, you can take the position that the cottage is owned by the child all along. One of the key benefits of this strategy is that it should prevent capital gains tax on the death of the parents, which would otherwise occur on future appreciation of the cottage, if held by the parents. This is particularly important when you acquire a vacation property that is intended to be held within the family after the older generation passes away.
Remember, though, that if you transfer a pre-existing property, the deemed sale rules apply, as discussed above. This means that if you want to do this sort of estate planning, you should do so before the property appreciates – so there’s no current capital gains tax exposure.
Another advantage of putting the cottage in the name of a child is that it may be possible to claim a second principal residence exemption. The one-principal-residence-per-family rule does not apply if a home is held by a child who is 18 or over. So an adult child (or even a child under the age of 18, if married) will still be able to claim the principal residence exemption if he or she holds the cottage and intends to use it for personal use.
While this sounds like a great idea, remember that the child must be eligible to claim a principal residence exemption in his or her own right. This means, for example, that the cottage must be occupied by the child for his or her personal use. But even if the child can currently claim the exemption, eventually, he or she may buy his or her own home and from then on will likewise be restricted by the one-principal-residence-per-family rule.
In the meantime, though, there will be benefits from the principal residence exemption in the form of a reduction in capital gains tax when the residence is eventually transferred or sold, based on the number of years in which the exemption was available.
Bear in mind, though, that putting ownership of the home in the name of a child may result in complications if the child runs into creditor or marital problems. Also, unless the cottage is owned by all of your children as co-tenants, it will be necessary to pick and choose which child receives the cottage – and you may not wish to do this. And even if the cottage is owned jointly by your kids, you will lose flexibility if it is later decided that some of the children should not share ownership in the cottage.
Previously published in The Fund Library on October 24, 2019 by tax and estate planning lawyer, Samantha Prasad. Portions of this article first appeared in The TaxLetter, © 2019 by MPL Communications Ltd. Used with permission.