In my last commentary I discussed the Globe and Mail's article “Six tax mistakes cottage owners should avoid”. While I addressed a few of the topics that were covered, I thought I would tackle the remainder before the cottage season closes out.
Changing the use of the property to income producing
While this may seem like a great way to generate income from your investment, it also has its drawbacks. The article draws attention to the fact there must be a disposition of the cottage on the date that the election to be income producing property is made. If you are eligible and choose to claim the principal residence exemption, this transaction may not have any immediate tax consequences - I explained the basics of a capital gains exemption on a principal residence in my previous entry. However, from that day forward until the sale of the cottage or your death you will be liable for paying tax on the annual rental income produced and any capital gains, if there is an increase in value in the cottage. Keep in mind that you can’t make a principal residence exemption with any other property for the period that you claimed on the cottage, i.e. if the cottage was elected as your principal residence from 2000-2015, an increase in the value of any other potential primary residence during that time would be taxable gain.
Selling the cottage to the kids for less than fair market value
This is a BIG mistake and can carry some serious tax consequences. The simplest way of explaining it, assuming you aren’t using a capital gains exemption, is that you, as a seller, are taxed on what the cottage is worth at the time of the sale and NOT what you sold it for, if it was sold for less than fair market value. Your children, the buyers, will eventually be taxed based on what they paid for it and NOT what the cottage was worth at the time of the sale. The result is double taxation and it can be a significant amount depending on the sale price and appreciation of the property. For example, let’s assume that the fair market value (FMV) of your cottage is $500,000, you originally paid $300,000 and have decided to sell it to the kids for $400,000. Canada Revenue Agency will consider there to be $200,000 of capital gains (FMV of $500,000 – original purchase price of $300,000) even though you only received $100,000 in capital gains. Your children will have a purchase price of $400,000 even though you paid tax on a sale price of $500,000. Assume the children sell the cottage a few years down the road for a FMV of $600,000, they will also pay tax on $200,000 of capital gains (FMV of $600,000 - original purchase price of $400,000). Essentially, between you and the kids, there will have been capital gains of $400,000 when there was only a true appreciation of $300,000 on the property. Even when you consider that only 50% of capital gains are taxable – that still equates to $50,000 of taxable income that never existed. As the article points out there are strategies to accomplish selling the cottage to your children for an amount that is less than fair market value without the double taxation, however you should sit down with financial planner to get specific advice about your circumstances.
As a personal use property you cannot claim losses - period. As a rental property losses can be claimed, but this type of use will limit your ability to claim the principal residence exemption. Before you decide to operate the cottage as a rental property you should discuss the benefits and drawbacks with your accountant and/or financial planner to determine if it makes financial sense for you.
Purchasing or inheriting a cottage can be a serious financial responsibility. For many it is well worth the expense as countless lifelong family memories are created there. Hopefully, by avoiding the mistakes that I have discussed you can keep the memories and your money!