Cold weather has arrived. But the off-season is a good time to think about what will happen to a vacation property in the long-term, and how to best pay tax on it. Without proper planning, vacation homes can quickly go from enjoyable escape to a source of financial and emotional stress.
Many owners tend to focus on the financial issues — capital gains taxes and probate fees — but it’s a mistake to ignore the human issues. Owners should find out what their children and other family members want. While this article will focus on capital gains (Part Two will cover probate fees), successful planning needs to start with identifying family goals. This initial step will provide the plan with a sense of direction, so you can present and employ the strategies that will best fit a client’s needs.
Gifting the property
Gifting a vacation property to someone other than a spouse may be a worthwhile option. This strategy is advantageous when the property’s value is expected to appreciate significantly in the future. When this method is used, the property is deemed to be disposed of at market value. If the sum of the original cost of the property and any additions during the ownership period is less than the market value when it is gifted, then a taxable capital gain occurs in the year of the gift.
Let’s consider the following scenario:
Diane purchased a cottage in 1995 for $110,000. In 2000, she spent $40,000 on an addition. The cottage is currently valued at $320,000. The area where the cottage is located is becoming popular and property values are consistently increasing. Diane is wondering if she should gift the cottage now to her intended beneficiary or bequest it in her will. If the cottage were to appreciate in value to, say, $500,000 at the time of her death, gifting it now would defer tax on $180,000 ($500,000 – $320,000) of capital gains that would otherwise be taxable to her estate. However, gifting it now results in a pre-payment of tax on $170,000 of capital gains ($320,000 – $150,000) unless the cottage can be classified as Diane’s principal residence (discussed later).
Bequests and life insurance
Typically a will has a clause specifying a beneficiary for the vacation property. If the property is transferred to a beneficiary on the owner’s death, life insurance on the original owner may be an effective way of dealing with capital gains on the deemed sale of the property on death. Essentially what it does is create a payout source for the expected tax payable. It’s fairly common to have the beneficiary pay the premiums since he or she will ultimately benefit when receiving the full value of the property. The new cottage owner can also use the insurance pay out to help fund operating and maintenance expenses.
Principal Residence Exemption (PRE)
It’s becoming more common — and is permitted by Canadian tax rules — to claim a vacation property as a principal residence, effectively making the capital gain on the disposition (or at least part of it) exempt from income taxes. A number of factors, however, need to be considered when investigating this option:
- Prior to 1982, each taxpayer in a family can designate an eligible property as a principal residence, so if a couple has owned both a primary home and a cottage for decades, the exemption is available for both homes for years up to and including 1981.
- From 1982 onward, the family is only allowed to claim one property as their principal residence, so the gains from January 1, 1982 to now on the vacation property should be compared to the gains on the city house. If the vacation property has appreciated more than the home, then consider designating it primary residence.
- If the owner has designated, or plans to designate, the city home as her primary residence, the vacation property can’t be designated the principal residence for the years the city home gets the designation.
- If the vacation property and surrounding land is larger than ½ hectare (about 1.24 acres), there may be a capital gain on the excess, based on the CRA guidelines.
- If the property was ever rented, this may impact whether it qualifies for the exemption.
- New reporting rules came into effect in October 2016.
Given these complexities, it’s crucial to calculate and evaluate all of the different scenarios before reaching a decision.