The Victoria Day long weekend recently kicked cottage season into gear and many taxpayers are thinking about whether to buy a summer cottage, sell one or give one to the kids.
Each of these choices has tax implications.
First, let’s say you’ve been renting the same cottage each summer for years and now the owner is settling some affairs and has asked if you’d like to buy it. You’ve spent many years there, your children have built up memories there and you plan to continue spending summers at the lake. You take the owner’s offer.
There are no tax implications for you that result from the purchase. There are issues, however, for the owner, which may apply to you later, as you’ll see below.
Canada Revenue Agency (CRA) will consider the cottage a personal-use property provided it’s used primarily by you or your relatives.
However, you’ll want to start tracking the adjusted cost base (ACB) of the cottage. The higher that figure, the lower any taxable gain you’ll have to report once you dispose of the property either by selling it or transferring ownership through gifting or inheritance.
The adjusted cost base includes the original purchase price plus qualifying capital outlays such as:
General repairs don’t count as capital improvements and you can’t value any work you personally perform on the home.
The excess of the proceeds of disposition deemed or realized over the ACB (and any selling costs) is generally a capital gain for income tax purposes.
If you simply sell the property, you can designate it as your principal residence, take the exemption on any capital gain and sell it tax-free. A cottage can be designated as your principal residence for each year in which you, your spouse or common-law partner, and/or your children were residents in Canada and ordinarily lived in it for some time during the particular year.
To optimize the benefit of the exemption, taxpayers generally apply it to the property with the greatest accrued gain. Keep in mind, however, the property can’t be income-producing during the years it is designated as a principal residence.
In the past, when you disposed of your principal residence, you didn’t have to report the sale on your tax return if you were eligible for the full exemption. That has changed. Starting with the 2016 tax year, the CRA grants that exemption only if you report the sale and designation of principal residence on Schedule 3, Capital Gains of your income tax return. You’ll be required to report basic information such as a description of the property, the date you sold it and the proceeds of disposition.
The rules of the principal residence exemption are complex, so consult with your tax advisor.
You generally can’t deduct a capital loss on your cottage when you calculate your income for the year. You also can’t use a loss to decrease capital gains on other personal-use property. When property depreciates through general use, the loss on its disposition is a personal expense.
If you’re primarily renting out the cottage, however, you may be able to claim a capital loss. But keep in mind that you may lose the personal-use exemption if you rent it out for most of the year. That exemption can come in handy to help shelter any gain from the disposition if the cottage appreciates in value.
If you rent it out only occasionally to help defray some costs of ownership, talk with your tax advisor about how to report income and expenses on your tax return.
This brings up the issue of the changing use of the property. On the day you begin to rent the place, CRA considers that you sold the cottage and, on that same day, reacquired it — with both transactions at the fair market value of the property on the day. Normally, the CRA won’t apply the change-in-use rule if you meet three conditions:
1) Your rental of the property is secondary to your use of it as the family vacation property,
2) You make no structural changes to earn income, and
3) You don’t claim depreciation (capital cost allowance) on the property.
If you don’t meet those three conditions, you’ll need to calculate and report a capital gains tax or loss on the difference between the fair market value and the property’s adjusted cost base (ACB). Under the new reporting requirements that started for the 2016 tax year, you’ll have to report the deemed sale on Schedule 3, Capital Gains or Loses, of your tax return for the year of the deemed sale.
Rental income is taxable, but you can claim some expenses to offset the income, including:
Another choice to make is whether you want to pass the cottage on to your heirs. If that is your goal, first check with them to determine if they want the cottage. If they do want it, you need to decide who gets it, how they get it and how they’re going to pay for maintaining it. If you can’t claim the principal residence exemption on the vacation home, the children will need to pay a capital gains tax when the second parent dies.
They should be prepared for a shock. Although the capital gains tax is 50% of the gain, the hit could be significant if you’ve owned the cottage for years given the rise in property prices.
You could transfer the property before you die — or gift it — and pay the tax. To avoid other potential complications, for example an ex-spouse of one of the kids makes a claim on the property, you may consider creating a trust.
Consult with your tax advisor, who can help you sort through all the financial and estate-planning implications.