The truth about saving for retirement as a freelancer

More than one in 10 Canadians are part of the gig economy workforce, and a further third are open to joining, according to a survey released this past April.

Given the volatile job market over the last two years of the pandemic, it’s no surprise more workers are seeking out flexible work that can help them balance their career and family needs and provide more autonomy and control.

[Read our blog post: Are you getting a pay cut by going back to the office?]

But there are trade-offs, too – less job security, no benefits, no paid holiday and crucially, no employer-funded retirement savings plan.

So what can freelancers do to better prepare for retirement? We’ve listed our top tips below.

1. Consider incorporation

While there’s a cost to setting up and maintaining a corporation, doing so will allow you to defer personal taxation on some or all of your income from your business activities. Any business income that is not withdrawn from the corporation will be kept as retained earnings and taxed at a corporate rate, which is much lower than your personal income tax rate. This may not be an option for everyone, but if you’re a freelancer earning an income in excess of $100,000, it’s almost a necessity.

In addition, you can choose how you receive your income. You can pay yourself a salary (and pay into CPP); pay yourself with dividends, which have better tax treatment than a salary, or take a blend of both.

The Canadian Pension Plan can be a valuable part of your retirement plan, especially for freelancers who may have had difficulty saving through their RRSP and TFSA. If you’re operating as a sole proprietor, you’ll be required to make both employee and employer contributions. However, for those who are incorporated, you will still need to pay both portions, but many opt to pay themselves a salary only up to the yearly maximum pensionable earnings for the Canada Pension Plan (CPP), to make the most of that program. For the remainder of their required personal income needs, they would then withdraw dividends, as they have better income tax treatment than a salary. 

2.  Pay yourself first

The older you are, the less time you will have to save, so your savings need to be higher than someone earlier on in their career. The power of compounding makes a monumental difference in both the amount you will need to save and the length of time you will need to do it. The earlier you start saving, the better.

How much to save depends on several factors. How much can you reasonably afford to save? What are your short and long-term financial goals and objectives? Do you know what your income needs will be in retirement?

If you have a consistent income, the best course of action is to set up an automatic savings plan and consider it an essential expense. Performing a cash flow analysis can help you determine a reasonable amount to contribute that aligns with your retirement goals. Sitting down with a financial planner to discuss these issues would certainly be beneficial.

For those with inconsistent incomes, it’s a little more tricky. You may want to consider setting up an automatic savings plan with the minimum amount you feel you can afford based on an average of your previous year’s earnings. If you can’t keep up with the automatic contributions, you can always reduce the amount, put them on hold or cancel them altogether. Ideally, you’ll be able to gradually increase these contributions as your income increases. You can also make lump-sum contributions when you’re able to build up some extra funds in your bank account.

[Read our blog: Why Amazon is a silent household budget killer

3. Set up a health spending account

If you’re incorporated, you can set up a health spending account (HSA) that allows you to make contributions from your company to an account that can be used for any CRA-approved health expenses (dental, vision, prescriptions, therapy, etc.). Unincorporated businesses including sole proprietorships and partnerships are eligible for an HSA plan only if they employ at least one arm's length (unrelated) employee who is full-time and has been continuously employed by the business for over three months.

Using an HSA means you’re using pre-tax funds from the company and not your personal income. However, some of the rules around single subscriber plans have recently changed. Your contribution amount is set annually and can’t be increased until renewal. Under the old rules, any unused contributions could accrue in the plan, which could help offset larger expenses in future years. 

Now, all unused contributions must be returned to your company upon your annual renewal – effectively starting each year with a $0 balance. That being said, any unused contributions that are returned to your company through a health spending account could then be reallocated towards your retirement savings.

If you’re a sole proprietor that isn’t eligible for an HSA, you can apply for individual/family coverage through an insurance company, like Manulife’s CoverMe or through your local Chamber of Commerce. The downside to this type of coverage is that if your annual claims are less than your annual premiums, you lose money as nothing is returned to you at the end of the year. Also, if the claims meet or exceed the annual premium, the premium will likely increase the following year.

4. Know when it makes sense to contribute to your RRSP

If you aren’t incorporated, or you are but want to save for retirement outside of the corporation, an RRSP is an excellent financial planning tool. However, it may not always make the most financial sense to contribute. The benefit of contributing to an RRSP is to reduce your taxable income, effectively deferring paying income tax until you withdraw it, ideally in retirement. However, you may not have a high enough income to warrant its use. 

There are a few downsides to using an RRSP. One is that the funds aren’t easily accessible and another is that any withdrawals will be taxable income in the year they are received. Additionally, that RRSP contribution room you used when initially depositing the funds will be lost forever. You could even end up in a higher tax bracket when you withdraw it.

[Read our blog: When you shouldn’t invest in your RRSPs]

As a freelancer, your income can be unpredictable. Let’s assume you are making automatic monthly contributions to an RRSP, and you start out the first six months of the year on track to meet your revenue targets. Then something out of your control slows you down during the second half of the year, and you fall well short of your income goals.

Aside from the obvious effects on your monthly cash flow, you wouldn’t have easy access to the funds you had been saving all year. Also, with a much lower income, the tax savings of those contributions will be much less. Instead, assuming you have the contribution room, make use of a TFSA. If you don’t have a great year in terms of income, you can access those funds without any tax implications, and you will regain the contribution room the following year.

Finally, if your income is in line with or exceeds your expectations, you can easily contribute the TFSA contributions you made during the year to your RRSP to get the tax deduction. Just remember to do it before Dec. 31st and not March 1st as the TFSA contribution room resets at the beginning of the calendar year.

Need help planning for retirement as a freelancer? I’d love to chat about your situation and develop a personalized plan to help you live out your retirement with confidence. Get in touch today to schedule a free consultation. 

Why Amazon is a silent household budget killer

Is Amazon destroying your finances? You might be surprised to learn how the money you’re spending with the online behemoth could be invested for a much bigger return in the long run.

Amazon has become a mainstay for Canadian families when it comes to household shopping. Running out of diapers or need more garbage bags? They’re only a click away and can be on your doorstep in as little as a few hours.

In fact, these benefits are so effective at getting people to part with their cash that the experience for many shoppers 'is almost like a drug.’

Small purchases leave a big dent

And this addictive behaviour is causing many of us to lose track of our spending habits, wreaking havoc on our budgets. Obviously, diapers and garbage bags are considered necessities. But that’s not all we’re buying from Amazon.

Many of us don’t realize that a few little items here and there really add up.

For example, check out this sunshade for your car or van that looks like the cockpit of the Millennium Falcon!

What a steal at just $45!

Image credit: Jason Butler from amazon.ca

Rinse and repeat and all of sudden you’ve spent $300 on things you could really live without.

OK, well, maybe not the sunshade. That’s definitely a necessity.

Buying more than we need

This phenomenon actually started years ago with Costco. You would go into the store to buy some toilet paper and toothpaste and end up pushing out two carts with a 3-foot receipt for $400 of stuff you truly have very little use for.

Did you really need a 12-pack of romaine lettuce and a 4-year supply of printer paper? Amazon has only made those impulse purchases that much easier. You don’t even need to leave the house to buy crap you don’t need; they will deliver it right to your door - at the click of a button.

A prime target for overspending

If you’re a Prime member, things could be even worse. A survey from 2019 found that Prime members spend an average of $1,400 on the online shopping platform every year, compared to $600 for non-Prime members.

And this study was conducted pre-COVID. Amazon’s Q1 profits in 2021 were up 220% compared to the previous year, which means we were all seeing a lot more Amazon packages on our doorstep during lockdown.

Run an Amazon audit

So how can we curb this out-of-control online spending? Some banking apps help track your expenditures, but they aren’t really able to tell you what was an essential expense from Amazon and what was a frivolous purchase.

The best course of action is to audit your recent purchases by looking back through the last 3-6 months of your Amazon order history and identify what was something you needed and what was something you wanted.

Figure out how much you are spending on the latter and decide whether you would be better served to put that money to save for your retirement or pay down your mortgage. Better yet, if you have children, start a Registered Education Savings Plan (RESP) and take advantage of a 20% grant from the government – you could get up to $500/year for free for your children’s education.

We did the math

Let’s put this into context. If you were to save the $300/month by abstaining from these impulse purchases and, instead, invested the cash in your TFSA, you would have over $20,000 saved over a 5-year period (assuming a 5% rate of return). That’s enough for a used vehicle or a month-long trip to Europe! Would you rather have some reliable wheels or memories to last a lifetime - or a taco toaster?

If you really want to punish yourself, you can also audit your spending on Uber Eats and Grubhub – but one step at a time.

Want to get a handle on your budget or need to set up some financial goals (like opening an education savings plan for your little [or big] one)? Get in touch today to set up a free financial consultation.

Are you getting a pay cut by going back to the office?

With COVID-19 restrictions easing or going away entirely in some places, many employers are asking employees to come back to work at the office.

While some employees may be ready to get out of their house and bring some socialization back to their work routine, we should explore what this shift means for you financially and how it affects your bottom line.

We’ve looked at three of the biggest costs when it comes to returning to the office, and we’ve shared an example of how this back-to-work mandate could be costing you a hefty chunk of your paycheque.

1)   Fuel & Parking

The return to the office couldn’t come at a worse time. As we prepare to exit a global pandemic and trouble brews in Eastern Europe, the price of fuel has hit an all-time high. With prices at the pump reaching almost $2.00/litre in early March, it’s important that we calculate the true cost to make that trip to the office. You will need to make a few assumptions on your fuel economy and know how far you travel to get to work, but you should be able to get a general idea of what your commute is costing you in fuel. We also need to account for any parking costs. While some places of employment provide free parking, others can have steep parking rates.

2)   Wear and Tear

Due to a number of supply chain issues, buying a vehicle post-pandemic does not come cheap. The cost of new and used vehicles has soared to record levels. With rising inflation, parts & labour costs for repairs have shot up too. Wear and tear is the cost to safely maintain your vehicle - think oil changes, new tires, brake pads, and any other general maintenance. There is also an element of depreciation to the resale value of the vehicle based on the number of kilometres it’s travelled. You’ll want to factor in some expenses for maintenance and depreciation when looking at your daily drive into the office. This isn’t an exact science as a 2022 Honda Civic is going to be less costly to keep in good working order than a 2002 Mercedes SL500. However, we should be able to apply a formula to determine what the wear and tear cost is per kilometre, based on the amount spent on maintenance and repairs, as well as depreciation from the distance you travel to and from work.

3)   Your Time

Time is truly our most valuable resource. We may not feel that way when we spend a Sunday afternoon lying on the couch binge-watching the latest season of Ozark on Netflix, but it certainly has significant value. So, we need to assign some financial cost to the time spent behind the wheel. The easiest way to calculate this is to break down how much you’re paid for your time by your employer. If you’re paid hourly, then it’s quite simple. If you’re paid a salary, then we can do the math to determine what an hour of your time is worth.

Here’s an example

Let’s look at a real-life example to see what this means in dollars and cents.

1) We’ll use a conservative estimate of the average commute for a Canadian worker, about 30 km each way – or 60 km round trip. Assuming you have fuel consumption at 9 litres/100 km, you’re in the region of about 6 litres of fuel per day, or 30 litres per week, for work travel.

With current gas prices at around $1.80/litre, that’s $54/week on fuel alone. And your place of work may even require you to pay for parking – this can vary, but let’s say you’re paying $5/day (which is low for most city centres) and add another $25/week for parking.

So, we’re at about $80/week for fuel and parking for a workplace that is 30 km from home.

2)     It’s hard to say exactly what the exact cost of wear and tear will be on your vehicle. This will vary based on the age and make of the vehicle. For simplicity’s sake, let’s say that it’s about $0.15/km for a 2017 Honda CR-V. This is what we can expect on repair and maintenance costs and the depreciation if driven about 15,000 - 20,000 km each year. Going back to our daily commute of 60 km, that’s about $9/day or $45/week for wear and tear.

So now we’re at $125/week with fuel/parking and wear & tear.

3)      A salary of $100,000 is roughly $48/hour – ($100,000 ÷ 52) ÷ 40 = $48.08. You get the point and can figure this out for your specific salary – there is a table below to help. For our example, let’s use a salary of $75,000/year. That 60 km commute is likely going to take you 45 minutes or more each way, assuming you’re doing any driving on congested major routes – think 401, QEW/403 or Gardiner Expressway in the GTA. That’s about 1.5 hours per day at $36/hour – which is $54/day or $270/week for the cost of your time spent commuting.

With the value for your time added back to the other travel costs, we are close to $400/week. Over a year, that’s roughly $20,000 - no chump change!

If you’ve been working from home for the last 24 months and your employer isn’t increasing your pay to offset your travel costs, then you’re effectively taking a pay cut to return to the office. With inflation on the rise and commute times getting longer, this won’t be getting better for you anytime soon.

Here’s the crazy part, if you were to continue to work from home and invested that amount each year in your RRSP/TFSA, assuming a 5% compounded rate of return, you would have accumulated over $250,000 in 10 years – compounded over an entire career of 40 years – it’s over $2.4 million.

If you’ve been called back to the office, then maybe it’s a good time to sit down and review your finances with a financial planner. If you are still working from home, you should talk to a financial planner about how to invest all your savings from not having to commute. Get in touch today for a free financial planning consultation.

When you shouldn't invest in your RRSP

Many Canadians think they should invest in their RRSPs every year, without exception.

But the truth is, there are situations where it's actually disadvantageous to contribute to your RRSPs - and there are likely more financially savvy ways you can invest your money in these circumstances. 

In this piece, we'll look at the two biggest considerations for investing in your RRSPs, and what you can do if it's not the right option for you.

1. How RRSP contributions affect your taxes 

The first reason for not contributing to your RRSP, or at least not now, would be for tax purposes. You’ve likely been told about the tax benefits of investing using a Registered Retirement Savings Plan (RRSP). The basics of the plan are that your ability to contribute is determined by your previous year's earned income (18% to be exact, up to a maximum annual amount). 

Once you have contribution room available, you can open an RRSP and make contributions up to that limit. Those contributions are then deducted from your taxable income in the year that they were made (including the first 60-days of the following year). Assuming, you’ve paid enough payroll tax, you should get a refund on your tax return. Seems like a no-brainer. RRSPs also serve as a valuable way to save for your first home, allowing you to borrow a down payment of up to $35,000 tax-free from your savings. 

However, we need to consider some other factors. RRSPs are not truly tax-free savings vehicles, like a Tax-Free Savings Account (TFSA). They are merely deferring tax to a later date, usually retirement. This is still a good thing, it’s just that when the funds are eventually withdrawn, every dollar is taxed at your marginal tax rate (your highest rate). So, the idea is to contribute while in a higher tax bracket now and withdraw the funds in a lower tax bracket later. 

Making sense of tax brackets

If you’re just starting out in your career, you may not find yourself in a high tax bracket. And when your income is low, you won’t be getting all the potential benefits of the tax savings by contributing to your RRSP. 

For example, if you live in Ontario and earn $60,000 annually, with a marginal tax rate of 29.65%, a $3,600 RRSP contribution ($300/month) will only save you $1,067 in tax. 

Meanwhile, someone earning $120,000 annually, with a marginal rate of 43.41%, will save $1,563 – a difference of 46% more tax savings on the same contribution. 

For some, a higher income may not be achievable in the near future, or at all, in which case you would want to consider what your retirement income would look like. If you would likely have a lower marginal tax rate in retirement, then it still might make sense to contribute. 

One last thing to consider is whether additional income in retirement could affect your eligibility for certain income-tested retirement benefits as all RRSP withdrawals are considered taxable income, which could reduce your benefit entitlement or make you ineligible.

2. How you will withdraw your funds

Another reason you may want to avoid investing in your RRSP is its lack of flexibility. There are many positive aspects to RRSPs, but also a few key drawbacks: 

1. You can’t access the funds without being taxed*

2. You lose your contribution room - forever. 

*Notable exceptions would be using the Home Buyers Plan (HBP) as a first-time homebuyer, and the Lifelong Learning Plan (LLP) to pay for education. 

This also means that an RRSP is not suitable for short-term savings or as an emergency fund. Thinks of it like this: you only want to put money in your RRSP that you’re comfortable not touching until retirement. 

When a TFSA makes more sense

With the advent of the TFSA, you now have the option to save money that is truly tax-free and possibly utilize an RRSP when it’s more advantageous. Once you turn 18 you will begin to accrue TFSA contribution room – which is the same amount for everyone and is indexed to inflation each year. 

Contributing to your TFSA won’t allow for any income tax deduction come tax time, but it does provide more flexibility. In addition, when making withdrawals, there is no tax to be paid on any investment returns and no amount is added to your income. 

Even better, the contribution room from any withdrawals will be returned to you the following January 1st. So, whether you’re creating an emergency fund for the next financial disruption, saving for a new car or some other short-term goal, a TFSA may be a better option.

While RRSPs have long been considered the defacto tax-advantaged savings plan, TFSAs are also extremely valuable financial planning tools. It’s not a one-size-fits-all situation and these are just a few of many considerations when looking at what is in your best financial interest. 

It’s important to sit down with a professional who can discuss this in more detail to determine what is best suited for you and your specific financial situation.

Remember, if you do decide to contribute to an RRSP for 2021, the deadline to do so is March 1st, 2022. 

If you're unsure whether or not you should be making RRSP contributions, book a free 30-minute consultation to find out what makes the most sense for you.

5 Common Misconceptions About Financial Planning

1.  You Don’t Need A Financial Advisor

What this really translates into is ‘help and advice are not worth paying for’. However, the vast majority of us rely on the skills of specialists to give us guidance and provide their services. Ask yourself this, would you perform your own appendectomy? Draft your own legal documents? How about re-wire the electrical panel in your home?  Maybe change the brakes on your car? Assuming you choose to attempt any of these tasks yourself, do you think you will do the job as well or better than a professional? More importantly, do you have the time and the expertise to get the job done right? Without proper education and training, attempting any of the above is either incredibly risky or reckless, possibly both. Strangely, for some people the thought of paying a professional to help them make sound financial decisions and develop healthy financial habits seems unreasonable. Independent research, as well as academic studies have proven that those who seek out professional financial advice are not only wealthier, they also have better saving habits and are more confident in their ability to meet their long-term financial goals. Isn’t that valuable?

2.  Financial Advisors Aren’t Trustworthy

It’s hard to say where this notion came from. Certainly the media plays a part and undeniably there have been cases of unscrupulous financial advisors. But individuals with a lack of ethics are not unique to the financial industry. There’s an abundance of vocations that have seen their fair share of misconduct; doctors, lawyers, police officers, teachers, mechanics, politicians - just to name a few. Nevertheless, in the eyes of some, the behaviour of a handful of financial advisors seems to have reduced the entire profession to be viewed as dishonest. Determining the trustworthiness of a financial advisor isn’t as hard as one might think. There are a few simple things you can do to help weed out the bad ones. First, perform a background check on the advisor's registration with the Canada Security Administrators, this will confirm who they work for and that they are who they say they are. Next, find out if there are any previous or outstanding disciplinary actions against them through the Ontario Security Commission. If the advisor has any credentials, like a Certified Financial Planner designation, you can contact the organization they are held with to confirm that the advisor is in good standing. Finally, and most importantly, talk to people. Request references and be sure to ask a lot of questions. If you still aren’t satisfied, don’t be afraid to ask for a few more – if the advisor is trustworthy they should be able to give you as many as you need.  Finally, use your judgement. If something doesn’t feel right then move on and find someone else.  Your financial advisor should be someone you implicitly trust; there is no room for doubt.

3.  Big Banks Are Best

Banks play an important role in our economy. They are the backbone of our financial system and it couldn’t function without them. Nevertheless, just because a bank handles your chequing account or holds your mortgage doesn’t mean that they need to be the ones to provide you with financial planning and advice. It’s conceivable that the investment recommendations that you receive from the bank may be biased. How so? Sales quotas and proprietary investment products aren’t necessarily designed for the benefit of the client, and in some cases they can potentially be a conflict of interest. If you are working with someone at a branch level, many times investment recommendations are made before there is a sound understanding of the client’s financial situation and their goals. With big marketing budgets and a significant presence in our communities, it’s understandable that many people find the big banks to be safe and familiar. However, like most public companies, banks tend to be accountable to one key group – their shareholders. You may be a ‘valued customer’, but your banks biggest focus is its bottom line. Shareholder happiness is a result of big profits. So from an investor’s perspective, is it better to be benefitting from that profit as a shareholder or adding to it as a customer?

4.  RRSPs Are A Type of Investment

“I don’t invest in RRSPs because they don’t earn enough”. Surprisingly, there are a number of educated people with a serious misunderstanding of what a Registered Retirement Savings Plan, or RRSP, actually is.  A RRSP is not an investment and it doesn’t have a rate of return. Think of a RRSP as a box that you are using to put your investments in. What you earn in your RRSP is based on what investments you put in that box. What is permitted as an investment in an RRSP varies, it could be a GIC, bond, stock, mutual fund, ETF or even certain mortgages (for a detailed list of what Canada Revenue permits click here). When your investments are in the ‘RRSP box’ any resulting investment income is not taxable. In addition, you are able to deduct the amount you put in the box from your taxable income in the year it was contributed. Depending on your income this can amount to some serious tax savings. When you eventually take the money out, which you will have to do at some point as there is a minimum withdrawal amount that starts at age 72, the entire amount withdrawn will be considered taxable income for the year in which you receive it. So, it is not so much a tax shelter, as many may believe, but really a tax deferral. The key principle is that you make contributions in your higher earning years and then withdraw your money in years when you have a much lower taxable income. As such, the RRSP can be incredibly valuable financial planning tool.

5.  Real Estate Is The Ultimate Investment

This is not a disagreement about whether or not to invest in real estate; it’s about investing EVERYTHING in real estate. If someone were to invest all their savings in one company it would likely be considered foolish. The pitfalls of this approach should be obvious - if your investment fails you put yourself at an incredible amount of risk to lose everything. Therefore one of the fundamentals of a sound investment strategy is to have proper diversification. In recent years we have seen the value of real estate skyrocket. This increase has led to many people putting most, if not all, of their savings in to the real estate market with the belief that it is risk-free and almost guaranteed to make them wealthy. The reality is that the real estate market is fraught with risk. First, consider the market risk – this is what the property is worth to a buyer. Much like the stock market the housing market fluctuates. What it is worth today is not necessarily what it’s going to be worth tomorrow. Next, there is the liquidity risk – which is the ability to find a buyer when you want to sell it. In some cases this can take years. Real estate is only worth what a buyer is willing to pay and only when they want to pay it. In addition, many don’t consider the ongoing costs associated with owning property – there is insurance, maintenance, and don’t forget the tax on any rental income and capital gains when the property is sold. When you do the math the rate of return on a real estate investment may not be as substantial as you had initially thought. Remember, technically your home is not an investment as the definition of an ‘investment’ is an objective to generate a profit. Even though the value of your home could increase between when you buy it and the when you sell it, your primary objective is to live in it. It’s also important to keep in mind that any profit from the sale of a principal residence is not taxable. Some real estate isn’t a bad thing; just make sure you’re not putting all your eggs in one basket.

It's not all boats and BBQ's... (Part 2)

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.

Losses

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!

It's not all boats and BBQ's...

As the summer is now upon us I thought it would be a good time to talk about recreational properties. I will reference a few of the points raised in the Globe and Mail article “Six tax mistakes cottage owners should avoid”. I am going to expand on some of the issues the author addressed so you have a better understanding as to why they are important.

Claiming a Principal Residence

I want to focus on the first two points of the article: tracking capital improvements and corporate ownership of a cottage. To provide some background on the matter, Canada Revenue Agency (CRA) allows you to claim a property as a principal residence to take advantage of the capital gains exemption – in essence you don't have to pay any tax on the increase in the value of the property when it is sold. So, if you own a cottage and a home it is inevitable that at some point you will pay tax on the appreciation of one of those properties. From a tax efficiency standpoint, the goal is to minimize how much is owed when that time comes. To do so will require a careful analysis of the financials of both properties, which can include the original purchase price, capital improvements, acquisition and disposition costs, market value and the type of ownership.

Tracking Capital Improvements

The first point of the article stresses the importance of tracking capital improvements on your cottage, or any recreational property for that matter. First, let’s determine what a capital expense is. In the eyes of CRA, a current expense is one that generally reoccurs after a short period. For example, the cost of painting the exterior of a wooden property is a current expense. Whereas a capital expense generally gives a lasting benefit or advantage; for example, the cost of putting vinyl siding on the exterior walls of a wooden property. Renovations and expenses that extend the useful life of your property or improve it beyond its original condition are usually capital expenses.

Cost vs. Market Value

So why is it important to track these expenses? Well, the additional costs of any capital improvements will increase your Adjusted Cost Base (ACB) on the property. What is an ACB? In simple terms it is the original purchase price in addition to some subsequent expenses you have incurred – items like capital improvements, legal fees, real estate commissions and land transfer tax. When selling or gifting the property, the difference between the ACB and the Fair Market Value (FMV) is used to calculate your capital gain – of which 50% is taxable. In other words, if you increase your ACB you will have less tax to pay when the property changes hands. When you consider the increase in the cottage real estate market in Ontario and the expense of maintaining a cottage, especially one that requires a lot of updating and repairs, tracking capital improvements can have a huge impact when it comes time to sell.  If you aren’t taking in to account capital improvements it could be a very costly mistake! 

Corporate Ownership of a Recreational Property

The second point in the article referred to the ownership of cottage by a corporation. This is generally not a good idea from a tax standpoint. Corporate ownership of cottage results in the loss of eligibility for the primary residence capital gains exemption, as previously discussed. You may think that because you don't live at your cottage full-time that this doesn't matter. However, in some instances it may be more beneficial for you to claim your cottage as your primary residence as it could have higher tax consequences than your home. Of course, this would need to be analyzed on a case-by-case basis.

Cottage Use is a Taxable Benefit

If you are the owner of both a home and a cottage, you can designate either property as your primary residence when you sell one of them. Allocating the capital gains exemption between two properties can be complicated and is definitely a subject for discussion with a tax professional. Another concern in corporate ownership of a cottage is the potential for a taxable benefit. CRA could view any personal use of the cottage as a taxable shareholder benefit. What does that mean? Well, whatever the going rate for rent is for your cottage (or one like it) will be considered a benefit to you that you must pay tax on at your top rate. So, if a similar cottage in your area cottage would generally cost $4000 to rent per week and you have a 40% marginal tax rate, spending a week at the cottage could potentially cost you an additional $1600 in tax. If your goal is to avoid a tax when you sell or gift the cottage to your children or other family members, then perhaps you should consider the use of a trust. I will talk about this next month. Until then, be safe and have a fun time at the cottage!

If you are a cottage owner we would love to hear from you. Have you been tracking capital improvements on your cottage? Is your cottage under corporate ownership? Please feel free to ask questions or leave your comments below.