Tax Q&A: Tax Planning Strategies For Cottage Owners

July 11, 2018

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Summer is here. For many Canadians, this is the time of the year when they head up to the family cottage. Typically, the concerns are focused on plumbing, dock maintenance, and mosquitoes, but that doesn’t mean that there aren’t tax considerations associated with cottage ownership.

As tax advisors, we get a lot of questions about the tax implications of owning a cottage or summer property. If you’re a Canadian resident who owns—or is considering purchasing—a cottage or vacation property within Canada, here are some frequently asked tax questions:

We’re considering renting out our cottage. Are there any income tax implications?

Yes. When you begin renting a personal property, other than incidentally or occasionally, you’re considered to have changed the use of that property for income tax purposes. This means that where you convert your cottage to a rental property, you will be deemed to have disposed of your cottage at fair market value (FMV) and tax will need to be computed on the difference between the FMV of the cottage at the time of the change in use and its adjusted cost base (ACB). Any resulting capital gain may be reduced or eliminated by using the principal residence exemption.

However, you can make an election to defer the deemed disposition on a change in use to a later year. By making this election, it may also be possible to continue to designate the property as a qualifying principal residence for up to four years, or even longer in the appropriate circumstances. There are specific guidelines for making this election and care must be taken not to inadvertently rescind it.

If we rent out our cottage are we able to claim expenses against the revenue earned?

Yes. While the revenues earned from renting your cottage will be taxable, you will be able to claim applicable expenses to offset this income. Expenses can include a reasonable portion of the operating expenses for the cottage, as well as costs directly associated with renting the property (such as cleaning, advertising, commissions or fees paid to rental agents, and property management fees). You may also be eligible to claim depreciation, referred to as capital cost allowance (CCA) for income tax purposes, against the rental income.

There are a few issues to keep in mind should you decide to claim CCA on your rental property:

  1. You may not claim CCA if doing so would either create or increase a rental loss. You may only claim enough CCA to bring your net rental income down to zero.
  2. If you claim CCA during the years that you rent your property you could have an income inclusion for tax purposes in the year the property is sold. Referred to as a “recapture of CCA,” this amount will be in addition to any capital gain realized on the sale of the property.
  3. If you elect to defer the deemed disposition on a change in use (discussed above), you cannot claim CCA. Doing so will rescind the election and cause the deemed disposition rules to apply in the tax year that CCA is claimed.

Where the costs you are allowed to deduct (aside from CCA) exceed the revenue earned, you may find yourself in an overall loss position. Your ability to use these rental losses to shelter other sources of income will depend on the individual facts. Generally speaking, the ability to claim a rental loss depends on the amount of personal use and whether the rental of the property is conducted in a commercial manner. This means the Canada Revenue Agency (CRA) will view the occasional rental of your cottage as being significantly different from buying a cottage as an investment with the intention of renting it out.

I’ve been told that when we decide to sell our cottage, there won’t be any taxes to pay. Is this true?

The sale of your cottage property will result in the realization of a capital gain if the value of your cottage increased while you owned it. However, the principal residence exemption may be available to reduce or eliminate the gain you realize.

A cottage can be designated as a principal residence (even if you don’t use it as your primary residence) as long as it is “ordinarily inhabited” at some point during the year. Ordinarily inhabited includes living at the cottage for only a short period of time as long as the main reason for owning it isn’t for the purposes of earning income. The CRA doesn’t consider incidental or occasional rental of a property sufficient to prevent it from qualifying as a principal residence.

Also, as mentioned above, if you decide to rent out your cottage regularly, the years that you rent out your cottage can be considered qualifying years for purposes of the principal residence exemption if you elected to defer the change in use when you began renting your cottage and if you meet certain other tests.

As a result, depending on whether the principal residence exemption is available to shelter the gain you realize on the eventual sale of your cottage—and to what extent it is available—you may be able to dispose of your cottage tax-free.

My husband and I sold our cottage this year and we also own a home. We want to claim the principal residence exemption. How do we do this?

If you intend to use the principal residence exemption, it’s imperative that you do so properly so you don’t jeopardize your claim. In your case, there are a couple things to be aware of in order to ensure that you benefit as much as possible from this exemption:

  • You and your spouse may designate only one of your residences as your principal residence for each year that you owned multiple residential properties. Prior to 1982, it was possible for each spouse to own a property and designate it as their principal residence, allowing a tax-free disposition of more than one residence per couple. Unfortunately, for property purchased after 1981, this is no longer possible and a choice will have to be made upon the sale of the first property as to which of the properties should be designated as a principal residence for each year. For properties purchased prior to 1982, the ability to make separate principal residence designations between you and your spouse still applies, but only for the years of ownership prior to 1982, and only where the properties are owned wholly by you or your spouse at the time of disposition. Deciding how to best utilize the principal residence exemption when you own multiple residential properties is rarely straightforward and often requires that you consider multiple factors, including predictions about whether the remaining residence will increase or decrease in value in the future. Depending on the circumstances, there may be situations where claiming the principal residence on the disposition of your cottage may not make sense.

  • Reporting requirements for the principal residence exemption changed as of Jan. 1, 2016. Starting with the 2016 tax year, you’re required to report basic information (date of acquisition, proceeds of disposition and description of the property) on Schedule 3 of your income tax and benefit return when you sell your principal residence to claim the full exemption. For dispositions in 2017 and subsequent years, in addition to reporting the sale and designating your principal residence on Schedule 3, you also have to complete Form T2091(IND), Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust). Note that if you sold your principal residence in 2016 or in a later tax year, the CRA will disallow the claim if you fail to report the disposition and designation of your principal residence on your income tax return. If you forget to make this designation in the year of the disposition, CRA may accept a late designation in certain circumstances. However, a penalty may apply.

Our family cottage is located on several acres of property. A real estate agent told us if we sell a portion of our property the gain will be tax-free. Is she right?

Cottages can often be located on a sizeable piece of property so it’s not unusual for a cottage owner to consider subdividing a property to sell off a portion of land as a means of realizing some value. The sale of land can create a capital gain. However, where a capital gain arises on a disposition of a vacant parcel of land that was attached to a property, it may be possible to shelter this gain by using the principal residence exemption.

Essentially, a principal residence is defined as the actual building plus any surrounding land that can reasonably be regarded as “contributing to the use and enjoyment” of the residence. Generally, the surrounding land in excess of a half-hectare (approximately 1.24 acres) is deemed not to qualify as part of the principal residence unless the taxpayer can prove that its use is necessary to the continued use and enjoyment of the residence.

Possibly, a taxpayer’s ability to claim the principal residence exemption on the sale of excess land may be supported in cases where that land can be shown to be necessary to the continued use and enjoyment of the property up to the time of its subdivision. Whether a parcel of land meets this criteria will rest on the facts, but the CRA has explicitly stated that land that was subject to specific zoning laws prohibiting it from being subdivided would qualify as part of the principal residence during that relevant time.

Note that the determination of whether subjacent land meets the criteria for principal residence must be applied on a year-by-year basis, with only those years in which the land can be shown to be necessary to the use and enjoyment of the property being eligible for the purposes of designating the property as a principal residence.

We’ve made significant renovations to our cottage, including a new roof and deck. Should we be keeping track of these expenses for income tax purposes?

It’s important to keep track of all of these costs since what you spend on your cottage can have an impact on what you may ultimately pay in tax when you sell or dispose of it.

When you eventually dispose of your cottage—either during your lifetime or at death—and the value of the property has appreciated, a gain is realized at that time on the difference between either the proceeds of sale (or the FMV of the cottage where the property is being transferred to a non-arm’s length party for less than its FMV) and the total of its ACB, and any selling costs. ACB refers to the aggregate of both the initial purchase price of the property plus any additional qualifying capital outlays made over the years you owned it. Note that if you inherited your cottage from anyone except your spouse, the initial cost will be the FMV of the cottage at the time you inherited it. There are also additional considerations if you or your spouse owned your cottage prior to 1972, or if you or your spouse made an election in 1994 to increase the ACB of your cottage by using the $100,000 capital gains exemption available at that time.

The excess of the proceeds of disposition, whether deemed or realized, over the ACB (and any selling costs) is generally a capital gain for income tax purposes. As previously discussed, the resulting gain can be reduced or eliminated, subject to the availability of the principal residence exemption. Where the principal residence exemption is unavailable, or insufficient to shelter the entire gain, half of the capital gain is included in your taxable income. Consequently, it may be beneficial to look for ways to minimize any gain by ensuring that the documented cost of the property is as complete as possible.

Determining what types of costs are capital costs, and thus added to the ACB of the property, can be confusing. The accompanying checklist can be used to identify the key elements to consider when determining the ACB of your cottage and the type of documentation you should retain to support those amounts.

Summer is a great time to escape the demands of city life by retreating to the cottage. But whether it’s a cottage, cabin or chalet, a vacation property is supposed to be a tiny piece of paradise to call your own, not a money pit that costs you more than you bargained for. Much like applying sunscreen, tax planning to mitigate potential pitfalls when buying, renting, or selling a cottage can help you minimize additional outlays and protect you from getting burned.

CHECKLIST OF COTTAGE ACB COMPONENTS AND REQUIRED DOCUMENTATION

Keeping accurate records of the cost of your cottage is crucial should the CRA ever ask for support for the ACB of the property. Proper records include the original purchase documentation you received when you bought the cottage, plus any invoices or receipts that support subsequent renovations or improvements:

Original acquisition of the property

Elements from the Purchase Agreement and other costs (documented by invoices, statements and proof of payment) include:

  • Purchase price of the cottage, if purchased after 1971 (there are additional rules applicable to properties owned on Dec. 31, 1971, or if you made an election in 1994 to increase the ACB)
  • If inherited or received as a gift, evidence of the value at the time of the gift or inheritance such as a valuation
  • Land transfer taxes on acquisition
  • Utility connection costs
  • Real estate commissions
  • Real estate inspections
  • Legal fees
  • Cost of a survey or title insurance
  • Other purchase agreement disbursements, other than reimbursements to the former owner for annual costs such as property taxes and utilities that were paid before closing
  • Repairs and maintenance related to properties acquired in a state of disrepair. Generally speaking, it may be possible to include costs that wouldn’t ordinarily qualify in the opening ACB such as costs related to replacing a roof, buying new fixtures, and plumbing, replacing flooring, etc. The key is that the state of disrepair was factored into the purchase price (i.e., the price would have been higher if the cottage was in better shape and these costs were incurred for that reason)

Improvements not directly related to the building

Make sure you include any improvements to the land that aren’t related to maintaining current elements. Costs can include a new septic system, a new well, a water system etc. Also, ensure that you include any improvements to the land such as correcting drainage problems, building a driveway or right of way, pathways, or fixed decks and docks. Moveable items won’t generally qualify (although the definition of moveable should be carefully considered from a practical perspective). Documentation needed includes invoices and proof of payment.

Renovations

Any change to the structure of a cottage that creates something that wasn’t present before will generally qualify as an addition to ACB. Documentation will include invoices (including details on the nature of the work as an improvement) and proof of payment. Examples include:

  • Adding new rooms or finishing a basement
  • Building a new deck or replacing an old deck with a larger deck
  • Moving walls or partitions inside the structure
  • Creating a new bathroom, including the cost of fixtures

Ongoing maintenance vs. building improvements

Probably the most difficult task is deciding whether repairs and maintenance costs are an ACB addition or just an ongoing expense that cannot be included in ACB. Generally, the test is whether the structure was improved versus just returned to a previous state of repair during your period of ownership.

A good example is a new roof. If the cottage’s roof was in good shape when you acquired the cottage, then there is a strong argument that just replacing the shingles is an ongoing cost. However, if you replace a roof with a different and higher quality type of roofing, that cost could be an ACB addition. A key element to consider, in addition to having documentation similar to that described so far, will be whether the documentation highlights why an improvement was made. Other examples where an improvement may have been made include:

  • New windows and doors
  • New flooring and panelling
  • Replacing bathroom or kitchen fixtures

A final note for those do-it-yourself (DIY) cottagers—you can’t capitalize the imputed cost of your own labour for a DIY improvement, but you can capitalize the cost of the materials you used for the improvement.

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The information in this publication is current as of June 15, 2018.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it,