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Summer cottages and other lakeside properties across the country are open for the season. Property owners are enjoying their chosen vacation spot as they sit by crackling fire pits or listen to the rain tapping on the roof. Many may wonder whether or how to pass it on to the next generation. Taxes are not usually at the forefront of such thoughts. They are, nevertheless, worth considering.
Cottages, like any personal use property including homes, are subject to tax on capital gains. Capital gains will eventually be taxed whether triggered by an actual sale of the property or a deemed disposition (when a Canadian resident dies, they are deemed to have disposed of everything they own at fair market value1). It is only through specific exemptions, such as the principal residence exemption2, that taxes can be eliminated on such property. I’ve recently been asked a few questions relating to the principal residence exemption and thought this would be a good opportunity to comment on it and provide information for some basic tax planning.
While the eventual goal might be to have one’s children inherit the vacation property upon one’s death, it is usually preferable from a tax perspective that the property pass first to the surviving spouse or to a spousal trust3. This is because the Income Tax Act allows taxes on any unrealized gains to be deferred until the death of the last surviving spouse, and absent any sale, the capital gain would only be realized on that spouse’s death. I think it’s also worth noting that gifting the cottage to the children during one’s lifetime triggers the gain even earlier since a gift is considered to be a disposition as well.
It may surprise some to learn that a cottage that is a vacation property can actually be designated as a principal residence even if most of the year is spent living in another home, provided that only one principal residence is designated for any given year. Canada Revenue Agency has stated their administrative view that “ordinarily inhabited4” (as required by the legislation) can include small portions of the year where a property was used for vacations. This assumes that the property meets the criteria of a principal residence, including that it was mainly for personal use of the individual, spouse or child and not to produce income.
In years prior to 19825, spouses and common-law partners owning a home and a cottage, respectively, could each claim one of the properties as their principal residence. This could effectively eliminate the capital gain on both properties. In 1982 and later, the rules changed to require spouses and common-law partners to designate only one property between them as their principal residence for any given year.
The exemption is calculated6 by first determining the gain otherwise realized on the sale (or deemed disposition), then multiplying that gain by the number of years plus one that the property is designated as the principal residence over the total number of years that the property was held. In essence, the greater the number of years designated as a principal residence, the greater the tax free portion of the gain.
One great thing about the principal residence exemption rules is that the principal residence doesn’t have to be designated as such until it is disposed of7 (or deemed to be disposed of), so the size of the gain on each property usually helps indicate which one to designate as the principal residence. If both properties are owned at the time of death, the executor may choose to use the exemption on the property with the larger gain. This decision becomes more complicated if one of the properties is sold prior to the other one.
As an example, let’s assume that Mr. and Mrs. A own a cottage that has appreciated in value by $306,000 since they purchased it in 1986. Their house in the city (city house) was purchased in 1980 and has an unrealized gain of $214,000. Mr. and Mrs. A are considering a sale of their city house, whereupon they will move into a condo or an apartment. They would like to keep the cottage for use in their remaining years with the intention of passing it on to the next generation. From an estate planning perspective, does it make sense for them to claim the principal residence exemption on their house in the year of sale? This decision is not always easy or straightforward and depends on a number of variables:
In this example, that is clearly the cottage, so it is at least worth considering the possibility of preserving the principal residence exemption for the cottage.
This is obviously difficult to predict. The assumption here is that the cottage will continue to be held until death. At the time the later spouse dies, there will be a deemed disposition of the property. The longer Mr. or Mrs. A lives, the greater the proportion of the total cottage gain they can shelter from tax, even if they’ve claimed the principal residence exemption on city house, whereas a shorter life expectancy might support paying the tax upfront and preserving the principal residence exception for the larger gain on the cottage.
Chances are this will correlate to some degree with Question 2 but this is also very difficult to predict. If the expectation is that the vacation home will continue to significantly appreciate in value, it may be more desirable to have the certainty of a tax-free gain on the cottage even if it means paying tax on the city house upfront in the year of sale.
If they were to decide not to claim the principal residence exemption on their house, there would be a large influx of income in that year (from the capital gain on their house). Net income over $67,668 in 2011 will result in claw back of OAS benefits. For many taxpayers, this claw back might not otherwise have occurred, but it can potentially mean the loss of approximately $6,000 per taxpayer. The effect of the claw back could outweigh any tax planning advantages in recognizing the gain today.
It may make sense from a tax perspective to reduce the tax bill on death, but this may be of little interest to Mr. and Mrs. A if it means foregoing vacations or other things that they value in order to pay taxes upfront; and finally.
Since a dollar today is worth more than a dollar tomorrow, we would prefer to pay taxes later rather than now, all other things being equal.
All of these variables will differ from taxpayer to taxpayer and will impact their ultimate decision. If the sale of the city house is not reported in the year that it is sold, it is implied9 that the city house is the principal residence for the years in which it was held. By default, those years cannot be used to reduce the taxes on the cottage.
It is always better to make that decision than to have it determined for you, which is why it is a good idea to plan ahead and recognize the tax issues surrounding vacation property. For assistance, please speak with your local MNP tax specialist.
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4IT-120 Par. 5
5Section 54 “Principal Residence” (c)
6Paragraph 40(1)(b) of the Income Tax Act
7Subsection 40(2) and Paragraph 7 of IT120R6
9Since paragraph 7 of IT 120R6 says that CRA administratively does not require these forms to be filed when the entire gain is eliminated, it is reasonable to assume that if nothing has been reported or filed, the taxpayer is using the principal residence exemption to eliminate the entire gain on their principal residence. The alternative is that it is an unreported capital gain.
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