Unless it’s a principal residence, you’ll pay tax on any gain in value
If the likes of Steven Spielberg, Goldie Hawn, Kurt Russell, Tom Hanks, and Bill Murray have been spotted vacationing at summer homes in the exclusive Muskoka lakes region of Ontario, there really must be something to the whole cottaging experience. And judging from recent price trends, demand for prime waterfront properties is as strong as it ever was. Owning a recreational property is almost iconic in Canada. But what do you do if you own a cottage now and want to sell to a willing A-list buyer? Right now, there’s plenty of incentive to cash in. What pitfalls should you watch for?
According to the Lakelands Association of Realtors, representing 680 Ontario Realtors in Muskoka, Haliburton and Orillia, waterfront property sales rose 3% in May, year over year, with a total value of $164.2 million, up 1.2% from May 2016.
The median price of waterfront properties (that is, the midway point between the highest and lowest prices) in May was $522,500, up 24.4% from May 2016.
The lure of those sunsets and long lazy days on the dock seem almost irresistible. For the Hollywood A-listers, owning a recreational property is not a problem, they just add it to their asset list of mansions, yachts, and bulging bank accounts, and let their accountants do the rest. For the rest of us, recreational properties come with their own sets of taxing problems, which are easy to overlook when you’re dazzled by that sunset, particularly when it comes time to sell.
What’s the first thing cottage owners should keep in mind when it’s time to sell?
Probably first and foremost in the list of things cottage owners new and old must remember is that you’ll always have a silent partner – the Canada Revenue Agency. Although the CRA won’t be there to pump out the holding tank (or in older properties, the septic system), fix the roof, replace the door after a winter break-in, haul in the dock (or repair it after ice damage), or find the leaky pipe in the crawlspace, they’ll sure be there for their cut when it comes time to sell the place: You’ll have to pay capital gains tax.
But aren’t the proceeds of residential real estate tax-free?
They are for your home. Not for your cottage or recreational property. That’s because your recreational property is typically not your principal residence. For tax purposes, your “principal residence” is the place where you live most of the time, and is thus exempt from capital gains tax when you sell. But most families can have only one principal residence. That means when you sell your recreational property, you’ll pay capital gains tax on an appreciation in the value of the property from when you purchased it.
So along with all those ongoing maintenance costs, property taxes, and other expenses associated with ownership of a recreational property, you’ll be paying a good chunk of any gain in value (less improvements, so keep those receipts) to the federal government – something north of 20% at least.
What if the cottage has been in the family for a couple of generations? Won’t the tax bill be huge?
Not necessarily. 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.
Can you avoid the tax by signing the cottage over to children or grandchildren?
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 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, better get some expert legal help.
It all sounds complicated? Where can cottage owners 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 white elephant in the woods.
© 2017 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. Securities mentioned are not guaranteed and carry risk of loss.