Cottages and taxes, taxes and cottages
Country Routes March 1997
This is the third of a three part series by an associate of mine who is an accountant specializing in estate matters. He has written some articles for various publications including one for the Financial Post magazine in January of this year titled, "Ten Ways to Beat the Taxman". He has given me permission to reprint them here in my monthly column along with the Canadian Moneysaver magazine where they appeared earlier in the 1990s. His firm, Quinlan Quinlan are located at 8 King Street in Toronto. Quinlan merged with Lawless in October 1996 to bring the firm under the Campbell Lawless banner.
Over the last few years the discussion of "cottage taxation" dealt with ways to use the $100,000 capital gains exemption to minimize the tax bite associated with cottage ownership. The exemption was removed on February 22, 1994 but smart taxpayers made use of the phase-out rules by making a capital gains election in their 1994 personal tax return. If you haven't filed the election you can still file a late election. You will owe a penalty but it could be quite small compared to the future income tax savings the election will permit.
What is cottage taxation?
For purposes of income tax, an individual is considered to have sold all of his or her property immediately before death. An exception is available if assets pass to a spouse. However, the issue will arise on the second spouse's death. In terms of cottage ownership, the "sale proceeds" deemed received by the deceased taxpayer are equal to the value of the cottage at the time of death. The excess of these proceeds over the cost of the cottage is considered a capital gain. Seventy-five percent of this capital gain is subject to tax in the deceased's final tax return. The catch -- where do the funds come from to pay the tax? Remember, an actual sale did not occur!
Principal residence exemption
Canada's best tax shelter! Most of us are aware that when a home is sold it is often tax free. This occurs because Revenue Canada does not tax the gain arising on the sale of a principal residence. Your principal residence does not need to be your city home -- your cottage, ski chalet, condo, mobile home, trailer or houseboat can also qualify. Where the accrued gain on the cottage is greater than the accrued gain on the city home, it may be preferable to claim the principal residence exemption against the cottage gain rather than the city home.
Gifting to children
If you believe your cottage is going to go up significantly in value from now until your death it may be wise to gift the cottage to your kids now. A gift is considered a sale for tax purposes so a capital gain will arise equal to the difference in the cottage value at the time of the gift and the cottage's cost. The tax on 75% of the gain will be due on April 30th of the year following the year of the gift -- the deadline for personal income tax returns.
Cottage trusts
Most are quick to see the income tax benefits of gifting or providing children with early inheritances. However, there are concerns with actually giving legal ownership to children. These concerns stretch from kids squabbling (not to mention squabbling with the parents!), responsibility for the upkeep of the cottage, to the kid's marriages breaking up. You can overcome these concerns by transferring the cottage to a trust rather than directly to the kids. A trust is an arrangement that separates control and registered ownership of property from its actual beneficial ownership. In a cottage situation the parents would retain control over the cottage until the later of their deaths. This would ensure the parents have use of the cottage as they please but on their death any gains since the transfer to the trust would not be taxed because they no longer legally own the cottage.
Sale of cottage to kids
Rather than gifting the cottage to the kids or using a trust arrangement you can sell the cottage to the kids. If the kids do not have the funds you can take back a mortgage that is forgivable on the death of the second spouse.
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