How to cut the capital gains tax hit
Thinking about selling the cottage, cabin, or lakeside getaway? Plenty of people are, especially those of the Baby Boom generation who are finding that maintaining two properties is increasingly time-consuming, tiresome, and expensive. And if the younger generation is no longer interested in keeping up a family cottage, there seems little alternative left but to sell. If you do decide to put up that “for sale” sign, bear in mind that the Canada Revenue Agency will come calling with a bill for capital gains tax. Depending on how long you’ve owned the cottage, it could be a big one. But there may be ways to soften the blow.
The Adjusted Cost Base
The most basic way to cut the tax bill is to try to reduce the size of the capital gain to begin with. The CRA calculates the capital gain on the sale of a cottage as the proceeds of the sale minus the cost of selling and the adjusted cost base (ACB).
The higher your ACB, the lower the net proceeds of the sale, and the lower your ultimate capital gains tax bill. Of course, the tax drones at the CRA are fully aware of this, so gains on second residences are often targeted for tax audits – just to ensure that the components of the ACB are documented and are all bona fide.
So what are the kinds of things that the CRA is likely to accept in your adjusted cost base?
* Costs of acquisition. You’ll need proof of the original purchase price or some proof of value if the property was a gift or inheritance. Also, if you made an election to increase the ACB in 1994, you’ll need some evidence of that. Other costs of acquisition include such things as legal and inspection fees, land transfer taxes, sales commissions, survey, title insurance, and repairs to upgrade a property that was in disrepair (e.g., a new roof, flooring, walls, and so on), but you’ll have to demonstrate that the original purchase price would have been higher without these repairs.
* Related property improvements. These include items not directly related to the building, such as a new water system, well, septic or holding tank, property drainage improvements, fixed decks and docks, and access driveway. It’s important to remember that these can be included in ACB if they are “new” and not a result of ongoing maintenance, which generally cannot be included in ACB. Receipts and proofs of payment are essential.
* Qualifying renovations. Here’s where things get a little fuzzy. Renovations that introduce elements to the structure of the cottage or residence that weren’t there before will generally qualify to be included in the ACB. Perhaps you added a bathroom (and all the fixtures), or a new deck, or even a couple of new bedrooms that expanded the size of the cottage. All these would be accepted in the ACB.
The test that CRA uses to determine whether the item is ongoing maintenance or an improvement is to assess whether the building has actually been improved as a result or whether it’s simply been restored to its previous state. So a coat of stain on old siding won’t count, but an upgrade from rotting wood siding to quality aluminum or brick would. Other types of improvements that generally are acceptable in ACB are new windows and doors, new flooring or walls, and upgraded kitchen and bathroom fixtures. Keep all receipts and proofs of payment.
The principles of principal residence
A more complex way to shelter capital gains on the sale of a cottage involves the principal residence exemption. According to the rules, you may designate one property per year as a principal residence for the family unit, which comprises you, your spouse or common-law partner, and children under the age of 18. To qualify as a principal residence you and your family must “ordinarily inhabit” the residence during the calendar year. In more aggressive tax planning there is some wiggle room here, as even inhabiting the cottage for a short period of time could qualify it for principal residence status.
For most people who own both a city home and a seasonal home, this won’t make much difference, unless they decide to sell both properties at the same time. In that case, the principal residence exemption may be allocated between the two properties based on a formula that prorates the number of years of principal residence designation. This sort of trade-off will require the assistance of a tax expert to help you decide where the most favourable capital gains exemption lies.
But designating your vacation property as a principal residence and claiming the principal residence exemption on it would be an option only if it makes financial sense – for example, if the average annual gain on the vacation property exceeds the gain on your home.
Another complicating factor relates to the use of part or all of your cottage property regularly to generate rental income. You can occasionally rent out a portion of your cottage without losing potential principal residence exemption if the rental use of the property is relatively small compared with its use as a principal residence, you do not make structural changes for rental purposes, and you do not deduct depreciation. But if you do not meet these conditions, you’ve changed the use of the property, and the
CRA will apply a deemed disposition on property, along with an immediate deemed re-purchase. That could attract a major tax hit. The CRA lets you choose to defer a deemed disposition on a change in use. It may therefore be possible designate the property as a qualifying principal residence for up to four years or more, but you have to dot all the i’s and cross the t’s to get this deferral.
Remember, too, that unless you report the gain on the sale of your vacation property, the CRA will assume you have designated it as your principal residence. So be sure to discuss you’re your financial advisor which property to designate as your principal residence before you put up that for sale.
If you’ve inherited the family cottage – a situation that many families now find themselves in – you or your parents or grandparents may have been able to take advantage of something called “Valuation Day,” January 1, 1972, which involved assigning an acceptable value to the property as of that date. Essentially, any capital gain before that date will not be subject to capital gains tax. The V-day value (less improvements made since then) for these types of properties is considered to be the adjusted cost base for determining capital gains tax. That could still be significant, even if you can whittle down the adjusted cost base with capital improvements made over the intervening 40 years.
If you’re thinking now about trying to dodge the tax hit by transferring the title to the recreational property to your kids or grandkids, or holding title in joint tenancy, be careful. The CRA will still treat any such transfer as a deemed sale, and still demand its cut in the form of capital gains tax.
It might be possible to keep the cottage in the family without incurring a deemed sale by holding the property “in trust.” Trouble is, you actually have to create a trust for this purpose and go through all the (expensive) legal procedures to make this happen. The CRA has heard it all, and is highly skeptical of claims for recreational properties held “in trust” where no legal trust exists, so if this is the route you want to go, you’d better get some expert legal help.
Where to get help
Recreational properties are something of an iconic Canadian institution. Some have been in families for decades and have great sentimental value. But times and tastes change, and often, young adults no longer have any interest or wish to take the time, effort, and trouble involved in maintaining a second property.
So if it’s time to take steps to sell or transfer the recreational property, or if you’re contemplating buying one, your best bet is to consult a qualified financial professional who can help you avoid or mitigate the many legal and tax pitfalls that can turn your cozy cabin by the lake into a tax trap with a view.
Rather than going through all these machinations, many cottage owners simply opt to purchase life insurance that will cover the tax on the deemed sale of the property on the death of the owner. Here again, you’re going to need some knowledgeable financial help, because it’s easy to buy too much insurance.