Aug 2017
Capital Gains on Cottage Property Sales
Millions of Canadians are fortunate enough to own a family cottage or vacation property. It’s the place where memories are made – the first giant sunfish you landed with your dad, the first time you ducked your head underwater, or the one and only time you beat a sibling in a swimming race from the boat to the dock.
What’s less exciting is the prospect of having to pay capital gains on a cottage property sale.
Unfortunately, though, there aren’t many assets left that don’t attract the attention of a Canada Revenue Agency (CRA) tax collector. While you can sell your primary residence (the place you live most of the year) without incurring a tax liability – an allowance pretty much all Canadian homeowners benefit from – cottages are a bit different.
Keep reading as we discuss how to calculate capital gains on a cottage in Canada along with ways you can minimize the burden.
How capital gains on your cottage property work
In contrast to your home, the cottage is deemed an investment property with looming tax implications that require your attention and planning now.
The rules are relatively simple. If you sell your cottage for more than its purchase price, the CRA will deem that to be a taxable event – unless you’ve taken certain measures, which we’ll explore shortly.
First, let’s look at how the CRA’s cottage capital gains tax works.
How to calculate capital gains on a cottage in Canada
Next, let’s look at how to calculate capital gains on a cottage in Canada. A capital gain is simply the difference between an asset’s original purchase price and its eventual sale value. Capital gains are taxed at approximately 25% in Ontario.
So, to give an example, let’s say the Gates purchased a family cottage for $500,000 years ago. The cottage is now worth $1.5 million, representing a capital gain of $1 million. The capital gains tax liability would be approximately $250,000 (25% of the gain).
The 1994 exception
If you bought your cottage before February 1994, you were eligible for a $100,000 lifetime limit for tax-free capital gains. (After that date, the exemption was done away with for all Canadians). Some Canadians who owned a cottage at that time filed an election with CRA to claim a deemed capital gain on the 1994 fair market value of the cottage. This then became the new cost base for the purpose of calculating capital gains taxes.
7 options for handling capital gains on a cottage sale
1. Create a fund for CRA cottage capital gains taxes today
Rather than waiting until you’re ready to sell your cottage to begin capital gains tax planning, start putting money away now to pay the bill.
The problem is making sure you are around long enough to accumulate the necessary funds. The second big problem is taxation. You would have to earn twice the amount needed in pre-tax dollars to pay the tax bill. That means saving approximately $500,000 pre-tax in order to have $250,000 after tax to pay the tax bill.
2. Borrow against your equity in the cottage
The problem with borrowing is that you must pay it back with interest, and the interest paid is not deductible. While cottage values continue to rise (along with most other real estate prices) there is no certainty as to what the market will be like when it comes time to sell. Other questions such as who will lend you the money? Will banks be tight with lending then? What will interest rates be like? These questions can only be answered with a crystal ball.
3. Sell the cottage
Many people have to sell their cottages or other investment real estate to pay taxes. This can be devastating when a family is forced to sell their property.
4. Buy life insurance
This is the most cost-effective way to deal with any tax liability. A joint and last-to-die life insurance policy costs much less than individual life insurance. When a couple buys it, the benefit will be paid on the second death, exactly the time those taxes will be due. Each spouse leaves the cottage to the other either by will or by right of survivorship if owned jointly. When the surviving spouse dies, the insurance benefit is paid to the beneficiary or the estate, providing all the cash required to pay the tax bill. The cottage itself is left to the children in the will.
Some parents may not have the money to fund the premiums, so in many cases, adult children get together and pay the parents' premiums.
For example, the annual cost for a single $250,000 individual life insurance policy for a healthy 65-year-old is about $7,600. The same amount of joint-and-last-to-die insurance covering two healthy 65-year-old spouses is roughly $4,500 a year.
5. Transfer ownership of the cottage to your children now
But you can't just sign the deed over to the kids or sell it to them at a below-market price. CRA will re-calculate the transaction based on fair market value and tax you accordingly.
Another problem with that approach is how the children will establish a cost based on the selling price, which CRA will deem to be the lower value, the one you tried to use with them in the first place. That means that if the children decide to sell the cottage, their eventual capital gains could be much higher.
6. Set up a trust for the cottage
This is called an inter-vivos, or living trust, which means you have control over your assets now and don't have to make an immediate decision on what should happen to the cottage. Trusts are popular because they provide you with control over your assets which get distributed to the beneficiaries in the future. While they do provide you with some flexibility, in most cases you will still be taxed on the capital gain at the time of transfer.
7. Sell your current home and designate the cottage as your principal residence
Your cottage may have appreciated more than your home. And you may also be at that stage in life when you want to leave the city behind you and move permanently to that winterized retreat. If you transfer ownership to a family member you can shelter the full amount of future gains.
Under the Income Tax Act, your cottage can be considered to be ordinarily inhabited during the year even if you only spend a few weeks of the year there and if you don't own the property to produce income, like rental income.
To avoid any confusion, CRA announced last year that it will allow the principal residence exemption only if you report the sale and designation of principal residence in the capital gains section of your return. You will also have to report when you purchased the principal residence, a description of it, along with the proceeds of the sale.
If you don't claim the exemption in the year you sell the residence, you will have to amend your return to claim the exemption, but applying for it late can translate into hefty fees and penalties.
Whatever you decide to do with the cottage, you should keep your children and grandchildren in the loop. They may not all want the cottage, especially if they have moved far away from home for business or personal reasons. Some may prefer cash rather than real estate, and others may indeed want the cottage. Equalizing this part of your estate can be tricky and you should consult with a professional to avoid future problems. Whatever you decide to do, discuss your plans with your family, and ensure family harmony by avoiding sudden blindsides and the unnecessary arguments that surely ensue.
But what happens if there are no children, no familial beneficiaries for the cottage? Consider donating the cottage to charity. As of this year, no capital gains tax is charged on the sale of real estate (and private company shares) if the proceeds go to a registered charity within 30 days. On top of that, donors will also receive a sizable charitable tax credit.
Capital gains when selling a cottage in Canada: Conclusion
A cottage is a great place for the family to schmooze and have fun. You may not be able to control the weather on those weekends, but you can assure blue skies ahead by seeking help from an experienced trust and estate planning professional who can explain the financial implications of dealing with the cottage for future generations.
Frequently asked questions about capital gains when selling a cottage in Canada
Do I pay capital gains when I sell my cottage?
If your cottage has risen in value since you purchased it and is not your primary residence, you will pay capital gains tax on the appreciation.
Can I gift my cottage to a child and avoid a capital gains tax?
Gifting your cottage to your child will not avoid capital gains taxes.
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.