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.