It was about 90 years ago that my great-grandfather built his first cottage. It had no running water, no electricity and an outhouse in the backyard. One day, some children from town played a practical joke and moved his outhouse back about two metres, exposing the hole. When nature called and my great-grandfather stepped into the hole, he decided it was time for an upgrade. So, he put plumbing in the cottage. Over the years, he made a lot of improvements and the value of the property grew.
Thousands of Canadians are heading to the cottage, or cabin, for this long weekend. Many of those properties have grown in value in a big way over the past year. It begs the question: How much tax will eventually be owing on the property, when will those taxes be due, and what can we do about it?
The basics
You could end up paying tax on your cottage property if it has grown in value, and those taxes will generally be due when you sell, transfer ownership or pass away – whichever comes first. As a general rule, pushing that tax bill as far into the future as possible makes sense, which often means keeping the property as long as you can.
But let’s face it, there are many reasons why this may not be practical. You may have to sell, or want to sell, for many reasons. Or perhaps you want to transfer ownership to the children before you pass away. What can be done about the tax liability?
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Consider these ideas:
Maximize your adjusted cost base
You’ll only face tax on the value of your property over and above your cost amount – that is, your adjusted cost base, or ACB. If you’re like my great grandfather and have improved your cottage over time, create a list of all those improvements. You may not have receipts for those costs, but don’t lose sleep over that. If it’s clear that those improvements were made, list them anyway, then estimate as best you can the costs. You should add those costs to your ACB. Canada Revenue Agency will not likely ask to see the receipts and, if the department does, you can deal with that battle at the time. There are court decisions that could help you at that time (speak to a tax pro). Going forward, keep any receipts or proof of the costs of these improvements.
Claim the principal residence exemption
As long as you “ordinarily inhabit” your cottage property (there is no definition of what length of time is required, but even a week or two a year should be fine), then you can generally claim the principal residence exemption, or PRE, to shelter all or part of any gain on the sale or transfer of the property, or upon your passing. Many people keep the PRE to shelter their city home from tax. But given the big jumps in value of many cottages over the past year, this should be rethought. It generally makes sense to shelter the property with the biggest gain per year of ownership – which could be the cottage today.
Transfer ownership today
The advantage of transferring ownership to your heirs today is that any future growth on the property will not face tax in your hands in the future. So, this is a type of “estate freeze” (where the future growth, and tax bill attached to that growth, is passed to the next generation). The challenge is that you could pay tax today when making the transfer. If you can claim your PRE, then there might not be a tax cost. And if there is going to be a tax cost, you’ll pay tax at today’s capital gains inclusion rate (just 50 per cent of capital gains are taxable today). It’s commonly believed that the capital gains inclusion rate could increase in the near future given the need for our government to raise tax revenue to pay for all the pandemic support that’s been provided. Speak to a tax pro or trusted financial adviser before you make a decision to pay tax on a transfer today.
Consider life insurance to cover taxes
Finally, dealing with a tax bill on the cottage can be as easy as buying a life insurance policy to cover the taxes upon your death. This way, you won’t leave your heirs in a pickle if they want to keep the cottage but don’t have much in liquid assets to pay the taxes owing. Take the time to understand what that tax bill might look like today, then consider a permanent life insurance policy that also allows for the tax-free accumulation of investments inside the policy.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.
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FAQs
One of the easiest ways to plan for the tax liability on your vacation property upon death is to fund the payment of the tax through life insurance. You could estimate the current tax bill and buy a permanent life insurance policy today to fund the estimated tax bill.
Do capital improvements reduce capital gains? ›
Even on rental properties, an increased cost basis due to capital improvements can help you reduce your capital gains taxes. Finally, if you use certain types of loans to make improvements, you might be able to claim the interest you pay for home improvements as a deduction on your taxes.
How does the capital gains exemption work? ›
You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 of your profits if your tax-filing status is single, and up to $500,000 if married and filing jointly. The exemption is only available once every two years. But it can, in effect, render the capital gains tax moot.
How do I avoid capital gains tax on Cottage Canada? ›
Principal residence exemption: If you dispose of a property that's considered your principal residence, there is no capital gains tax payable when you sell or when you are deemed to have disposed of the property (assuming it has increased in value).
What is the cottage property tax in Ontario? ›
How much are capital gains on a cottage? In Ontario, capital gains tax on a property is generally 25% of the appreciated value. So if you incurred $1 million in capital gains on your cottage property, the CRA's cottage capital gains tax would be approximately $250,000.
What home improvements are tax deductible IRS? ›
Complete IRS Form 5695: To claim a deduction for energy-efficient home improvements, use IRS Form 5695. This form allows you to calculate the Energy Efficient Home Improvement Credit. Examples of eligible improvements include solar panels, energy-efficient windows or upgraded heating and cooling systems.
What does the IRS consider capital improvements on a home? ›
The IRS defines capital improvements as those that endure for more than one year upon their completion and are durable or permanent in nature. Internal Revenue Service.
How can I legally avoid capital gains tax? ›
Here are four of the key strategies.
- Hold onto taxable assets for the long term. ...
- Make investments within tax-deferred retirement plans. ...
- Utilize tax-loss harvesting. ...
- Donate appreciated investments to charity.
The capital gains tax over 65 is a tax that applies to taxable capital gains realized by individuals over the age of 65. The tax rate starts at 0% for long-term capital gains on assets held for more than one year and 15% for short-term capital gains on assets held for less than one year.
What is the 6 year rule for capital gains tax? ›
The capital gains tax property six-year rule allows you to treat your investment property as your main residence for tax purposes for up to six years while you are renting it out. This means you can rent it out for six years and still qualify for the main residence capital gains tax exemption when you sell it.
You cannot depreciate a vacation home, which is considered personal property. But because it's a second property, when you sell, it is fully taxable at the capital gains rate as an investment.
What is the lifetime capital gains exemption? ›
When you make a profit from selling a small business, a farm property or a fishing property, the lifetime capital gains exemption (LCGE) could spare you from paying taxes on all or part of the profit you've earned.
How do I calculate capital gains on sale of property? ›
Subtract your basis (what you paid) from the realized amount (how much you sold it for) to determine the difference. If you sold your assets for more than you paid, you have a capital gain.
What is a cottage in real estate? ›
They are small homes, intended to house a single family. Cottages are typically asymmetrical, one to one-and-a-half story dwellings with low-pitched gable roofs and small covered porches.
Is owning real estate a type of tax shelter? ›
A tax shelter is when you use a real estate investment property, investment account, or transaction to lower your income tax rate. It reduces the income tax owed through deductions and credits. Examples include: Claiming tax breaks like property depreciation expense.
Can you have two primary residences in Canada? ›
A Canadian taxpayer may only designate one home as their principal private residence for a particular year. According to Canadian tax rules, a home can be designated as a principal private residence for each year in which a taxpayer, their spouse, common-law partner, or their children were residents in Canada.
What improvements can be offset against capital gains tax? ›
Examples of this are replacing a boiler, re-wiring, windows, roof, kitchen & bathroom and so on. They do the same thing as before. Capital expenses are considered to be improvements, such as structural changes, eg new conservatory, extension where there was nothing there before.
What lowers capital gains tax? ›
Long-term investing offers a significant advantage in minimizing capital gains taxes due to the favorable tax treatment for investments for longer durations. When investors hold assets for more than a year before selling, they qualify for long-term capital gains tax rates, typically lower than short-term rates.
Can you write off capital improvements? ›
Capital improvements don't include home repairs and must be permanent or semi-permanent changes that are not done out of necessity. Tax deductions for capital improvements can only be realized when the house is sold. The renovation's value, or a percentage, is added to the investment cost of the home.
What costs can be offset against capital gains? ›
Types of Selling Expenses That Can Be Deducted From Home Sale Profit
- advertising.
- appraisal fees.
- attorney fees.
- closing fees.
- document preparation fees.
- escrow fees.
- mortgage satisfaction fees.
- notary fees.
