Beware capital gains tax on non-principal residences
With real estate prices going through the roof across the country, you may seriously be considering selling the family cottage to capitalize on the investment your great grandparents made 50 years ago – or that you made 10 years ago. Trouble is, you have an uninvited partner in the sale: the Canada Revenue Agency, waiting to take its cut of the proceeds. Here’s how to reduce the tax take on a cottage sale.
Very broadly, you’ll end up paying capital gains tax on the sale of your cottage. That’s because for tax purposes, your recreational property is typically not your principal residence. Your “principal residence” is the place where you live most of the time, and is exempt from capital gains tax when you sell. Most families can have only one principal residence, so when you sell your cottage property, you’ll pay capital gains tax on an appreciation in the value of the property from when you purchased it. But there are ways to cut the tax bite.
How the CRA calculates the gain
The Canada Revenue Agency 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). Here’s where things get interesting, especially if you’ve owned the cottage for a long time.
If you’ve inherited the family cottage, 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 ACB with capital improvements made over the intervening 40 years.
How to avoid an audit
Of course, whittling down the ACB on a long-held cottage is a tried-and-true tax reduction method, of which the Canada Revenue Agency is fully aware. As a consequence, reported gains on sales of second residences are often targeted for tax audits – so make sure all the components of the ACB are documented and are all bona fide costs and expenses.
Here’s what the CRA primarily looks for:
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. You’ll have to demonstrate that the original purchase price would have been higher without these repairs.
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. 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 are essential.
Qualifying renovations. 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 – say, an extra bathroom (plus the fixtures), or a new deck, or even a couple of new bedrooms that made the cottage bigger.
To determine whether the item is an “improvement” or “ongoing maintenance,” the CRA looks at whether the expenses were incurred simply to restore the building 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. New windows, doors, flooring, walls, and upgraded kitchen and bathroom fixtures would all qualify.
Don’t forget to report the sale
Report the gain on the sale of your recreational or secondary property when you file your taxes for the year, or the CRA will assume you have designated that property as your principal residence. That could cause all kinds of problems down the road when you decide to sell your “real” principal residence. So if you have more than one property that could be designated as a principal residence, be sure to discuss which one to designate as such with your financial planner before you put that cottage up for sale.
© 2016 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.