Reducing capital gains on a cottage
With planning and the right documents, the capital gain tax owing on a family cottage can be lowered. Here are three different situations that show how.
With planning and the right documents, the capital gain tax owing on a family cottage can be lowered. Here are three different situations that show how.
Got questions about capital gains tax and cottages? Here are three MoneySense reader questions answered by Certified Financial Planner Jason Heath.
Planning to leave the family cottage to your kids in your will? Here’s how to minimize capital gains tax as part of your estate planning.
By Jason Heath, CFP on October 23, 2023
My father-in-law was convinced by his local accountant that the family cabin would not be taxed upon his and his wife’s deaths, because he had put all three of his children’s names on the ownership title.
I said that I was unaware of any mechanism that existed to avoid capital gains tax by doing this (his primary residence/house would be worth roughly the same amount as the cabin, so that’s not relevant). I wasn’t sure how probate played into it.
Anyway, do you have a resource you point people to on this? I’m thinking that we should probably start bugging him not to get all of his bills together, from over the years, to make sure that the capital gain is as low as possible.
Capital gains tax generally applies to real estate in Canada. The primary exception is the principal residence exemption that can be claimed on real estate ranging from houses to cottages to cabins to mobile homes.
In order to claim the principal residence exemption, a taxpayer must typically use the property in question, even if it is not the place they primarily live. Assuming the property has not been used for business or rental purposes, the sale proceeds of a principal residence can generally be completely tax-free.
While it is possible to claim a cottage or cabin and have the proceeds be tax-free, it would be uncommon. A taxpayer’s home is usually worth more than a secondary or vacation property. But, of course, it depends on the circumstances.
In this case, Cal, I worry that either the accountant misspoke or your father-in-law misinterpreted their advice. Although your in-laws could claim the cabin as their principal residence, doing so would expose some or all years of ownership of their house to capital gains.
A taxpayer can only claim one principal residence for a given tax year. So, say they have owned their house for 35 years and the cabin for 20 years. Say they sell the cabin now and claim the principal residence exemption, and then sell their house in five years. For the house, 20 years out of 40 years, or half of the capital appreciation, would be tax-free. But the other half would be taxable. These 20 years come from the first 15 years prior to owning the cabin and five more years after selling the cabin.
Note that the value of the house when the cabin was purchased and its value when the cabin is sold are not relevant. The capital gain would be a pro-ration based on the years of ownership going back to the house’s original purchase price plus any adjustments.
It is also worth noting that Canada did not have a capital gains tax until 1972, so properties owned prior to that year would need to be valued as of Jan. 1, 1972. There was also a capital gains exemption of $100,000 that was eliminated in 1994, but taxpayers could elect to realize a notional capital gain and bump up the adjusted cost base of certain assets, like real estate, at that time. These situations may or may not apply to your in-laws.
You claim the principal residence exemption on your tax return for the year in which you sold a property. So, it is not something you need to decide ahead of time. In your father-in-law’s case, Cal, if he and your mother-in-law intend to keep both properties forever, we should consider the tax implications upon death.
When you die, if you leave capital property like real estate to a surviving spouse, the default position is that the property passes to the surviving spouse at its original cost, plus any adjustments. So, no capital gain is triggered.
You can elect to have a capital gain or a partial one if it makes sense to do so. Say, for example, the deceased had a low income in the year of death, or other tax deductions or credits that their executor wanted to claim against the income and tax payable.
Capital gains tax would generally only become payable when the second spouse passes or if a property is left to someone other than the surviving spouse.
You mention keeping receipts, and given that the values of the two properties are similar, your in-laws may want to have a record of expenses for both. One document to keep might be the lawyer’s statement of account for the purchases, which shows legal fees, land transfer tax and other closing costs. If your in-laws don’t have these statements, the lawyer(s) may be able to provide copies.
Also, receipts related to renovations and capital improvements to the properties are relevant. These costs, as well as the eventual selling costs like the realtor’s commission or legal fees, may reduce the capital gain.
The fact that your father-in-law has added his children’s names jointly on the cabin has several implications. For one, by default, this approach generally results in the presumption of resulting trust, where only the legal ownership of the property has become joint. Beneficial ownership remains with your father-in-law and mother-in-law. Beneficial ownership means who technically owns the property. If everyone still acts like it belongs to them, they still pay the ongoing costs, and nothing has really changed since they added their children’s names, no change in beneficial ownership has occurred.
In that case, the good news is that there’s no capital gains tax payable at the time they added their children’s names to the cabin’s title. Otherwise, if a gift of part of the property took place, your in-laws would have a deemed disposition, which would have to be sheltered from tax by the principal residence exemption or taxable as a capital gain. Even though no money changes hands, a transfer to a non-arm’s-length individual like a child is considered to take place at the property’s fair market value.
Interestingly, the common approach of adding children’s names jointly on assets may not help people avoid probate after all. If beneficial ownership has not changed, an asset may need to be disclosed on a probate application and be subject to capital gains tax. The best approach for tax, probate and legal reasons when adding children’s names to real estate or a bank or investment account, such as a tax-free savings account (TFSA), is to write a declaration of the intention for doing so.
Due to two recent tax changes, there may be other unintended consequences for your in-laws and their kids.
Anyone considering adding a family member jointly on title to real estate or other assets should consider the income tax, probate, underused housing tax and trust tax implications and filing requirements. Seemingly simple strategies may have unintended consequences and complexities and require advice from multiple kinds of professionals.
In your father-in-law’s case, Cal, he may want to dig a little deeper with his accountant and consider estate law advice here as well.
Phylis and her son own a cottage together. She wants to understand the future tax and estate planning implications
By Jason Heath, CFP on June 12, 2018
My son and I have purchased property and built a cottage. I am now going to will my share to him. We have done the majority of work ourselves but purchased some equipment to help us, including an excavator and skidster, and my son also built a barge because the property is only water access. Can we claim any of this equipment when calculating out the adjusted cost of the cottage?
You’ve raised a number of different points, Phylis. You mention willing your share of the cottage to your son. I suspect that may mean you both own your shares as tenants in common, meaning your 50% interests are separate and distinct and can be dealt with separately—including in your wills.
If so, you certainly can designate your share of the cottage to go to your son in your will.
I find people are often confused with joint ownership though. If your ownership was actually established as joint tenants with rights of survivorship, your share would pass to your son directly on your death (and vice versa) and would not pass through your will at all. So make sure you know how the ownership was established initially, Phylis, so you understand the estate implications.
You could consider changing ownership from tenants in common to joint tenants if you both wanted the property to go to each other on death, though your son may have other beneficiaries like a spouse or his children who he wants his share to go to instead. Joint tenancy may help you reduce or avoid having to pay probate fees to your province of residence to settle your estate on your death. Depending on your province of residence and the cottage value, probate could be thousands of dollars.
When a taxpayer owns multiple properties, like a house and a cottage, only one can be designated as her or his principal residence in a given year. When you sell a property—or when you’re deemed to have sold, on your death—that’s the point at which you make a designation as to whether some or all years of ownership are tax-free as a principal residence.
People’s homes tend to be more valuable than their cottages, in which case the cottage capital gain is often deemed to be a taxable capital gain, with a home being their principal residence.
There are other considerations if you owned the cottage prior to February 1994. There was a $100,000 lifetime capital gains exemption until that time, and you may have claimed a deemed capital gain to bump up your cottage adjusted cost base. And if you owned prior to 1972, there was no capital gains tax before January 1, 1972 and some of your cottage capital gain may be exempt from tax.
Assuming you and your son, Phylis, will have capital gains tax to pay on the cottage, the construction, capital improvements and renovations you did may reduce the future tax payable by increasing the cost base and reducing the capital gain. It’s important to keep proper records to support a claim. It’s also important to note that if you do work yourself on a cottage, you can’t put a value on your labour—you can only add labour paid to a third party to the cost base for capital gains tax purposes.
There’s another important point with respect to the excavator, skidster and barge. You can generally only capitalize the cost of materials for a do-it-yourself cottage build. Equipment you purchase has a value after the construction is done and could be sold. The cost of equipment you rent or lease during construction may be an eligible capital cost.
There are a few other considerations, Phylis. Assuming the property was beneficially half yours, and that you and your son contributed equally to the purchase and construction, you would have a capital gain on your death (as long as the cottage wasn’t considered your principal residence). If you were just on the property so your son could qualify for a mortgage and it was beneficially his, you may not have to claim a capital gain.
Another consideration is ensuring there is enough liquidity in your estate to pay the capital gains tax. If you have other children or other beneficiaries, just make sure you take into account how much tax will be payable on the cottage and what that means for the remaining net estate value to be divvied up amongst others if applicable.
Fred’s mother wants to claim the cottage her principal residence before selling it to the kids.
By Jason Heath, CFP on August 5, 2014
My mother leases an apartment in a retirement community, but also has a cottage. Can she declare the cottage as her principal residence? How can she avoid or minimize the taxes on the sale of the cottage to her children?
Every Canadian can have one principal residence for tax purposes. It doesn’t have to be your home. It can be your cottage. If you only have one property, selling it generally has no tax implications. Your mother owns a cottage, like many Canadians, so the result is that there are likely capital gains tax to pay in the future.
In your case, Fred, you’ll need to look into the past to get your answer. If your mother had a home that she owned previously, it is likely that when she sold it, she didn’t report a capital gain or pay income tax on that sale. If that’s the case, if we assume she sold it in, say, 2010, the cottage will qualify as her principal residence for subsequent years, but not prior.
If she bought the cottage in, say, 1990 and she sells it in 2014, she will have owned it for 25 years upon the sale. But for only 5 of those years (2010-2014 inclusive) will it be her principal residence and qualify for a tax exemption.
If she has a $100,000 gain based on the original purchase price, 20/25ths or 80% would therefore be taxable to her.
If she owned the property prior to 1995, you should see if she made an election up to and including 1994 to increase the cost base of the property by way of the $100,000 lifetime capital gains exemption that used apply for Canadians.
If she owned the property prior to 1982, the property may be exempt from tax prior to that point because she and your father were both allowed to designate one property each as their principal residences.
And if she owned the property prior to 1972, the capital gain prior is tax-exempt as capital gains taxes weren’t payable by Canadians until that time.
Renovations or improvements made over the years may qualify as capital costs that can be added to her original purchase price and decrease the ultimate capital gain.
If she’s going to sell the cottage to her children, the property needs to be sold at fair market value. In other words, you can’t choose an arbitrarily low value to reduce the capital gains tax.
You and your siblings might consider buying the property from her over a period of 5 years if the capital gain is quite large, depending on her tax situation and need for the sale proceeds. This way, as little as 1/5 of the capital gain would be taxable to her in each year over 5 years due to a capital gains reserve.
No matter what you do, Mom is going to pay tax on the cottage eventually. Whether she sells it to you kids or is deemed to sell it when she dies, in her case, a taxable cottage capital gain is as inevitable as death and taxes.
Sometimes, when it comes to cottages, I find people get carried away with avoiding or reducing capital gains tax or probate fees, but end up incurring significant and unforeseen costs. So I think tax should be just one of your concerns here, Fred.
If your mom genuinely wants to sell the cottage to you and your siblings and you all want to buy it, that’s one thing. But if you’re doing so just to get it out of her name and stop the capital gains tax clock, you should take into account other considerations.
In particular, your mother would give up ownership and exclusive use of the property on the sale. Is that what she wants? How will you guys decide who uses the property and when? Shifting ownership of the property from Mom to you guys directly could create a sense of entitlement that makes battles for prime weekends more intense. Make sure you set ground rules ahead of time with your siblings. Who will pay for the property?
Presumably, Mom has been paying property taxes, utilities, insurance and repairs up to this point. If you kids buy the cottage, make sure you have a game plan and that you all agree on how the costs are going to be divvied in advance.
And while death, taxes and cottage capital gains are all inevitable, keep in mind the fact that divorce is about 50% inevitable right now in this country. If you guys buy the cottage from your mother now and you use it with your families, for marital and family law purposes, your share of that property becomes family property that may be divisible with your spouse in the event of a divorce.
So, just remember, your mom may be able to avoid or reduce the capital gains tax on the eventual sale of the cottage with the principal residence exemption, but there are other potential costs of selling the cottage to you that need to be considered before a sale occurs.
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