Tax consequences of a sale
Basically, there is essentially a one-principal-residence-per-family rule
(with some tax relief still potentially available for second properties
owned prior to 1982). What this means is that if you sell or transfer the
cottage, capital gains tax may be payable on your “home away from home.”
You should assume a tax rate on capital gains of about 26% of the
appreciation in value. So, any sale of the cottage at today’s value will
result in a capital gain equal to the sale price less the “adjusted cost
base” of the property to you. Very simply, the “adjusted cost base” is the
cost you paid to acquire the property plus all capital improvements you
made to it over the years. If you inherited the cottage from previous
generations by way of a will, your cost of the property will be equal to
the fair-market value of the cottage at the time that you inherited it.
You should also ask yourself whether you have owned the cottage since
before 1972. Why that far back? Well, if you owned property prior to
December 31, 1971, you were able to take advantage of what is called
“Valuation Day,” or “V-day.” Since capital gains were only taxable from
1972 onwards, the increase in the value of your cottage prior to December
31, 1971 (i.e., V-day) is exempt from a capital gains tax.
Accordingly, you (or your parents or grandparents) were able to elect the
fair-market value of the property as at December 31, 1971, to be your new
cost base for future capital-gains calculation purposes. So, if you owned
your cottage prior to V-day, you may want to check to see what your V-day
value is in order to determine what your effective cost base would be.
Plus, if you made any capital improvements since V-day (presumably this
would be the case, since your cottage likely would have required some work
over the past 45 years), those improvements can be added to your V-day
value in determining your adjusted cost base.
When it comes to selling the property, you have to designate either your
principal home or your cottage as your principal residence in order to get
the principal residence exemption. If you think that your capital gain on
the sale of the cottage would heavily outweigh any possible gain on the
principal home for those years that you owned both, then you may want to
designate your cottage as your principal residence and claim the exemption.
However, this becomes an exercise in numbers to determine where your
biggest tax liability lies.
Transfer within the family
In many cases, you may want to rid yourself of the cottage but still keep
it in the family by transferring it to a family member (i.e., your kids or
grandkids) for estate planning or other reasons. However, our tax rules are
clear: If you transfer a capital asset – be it a second home or otherwise –
to a related person other than your spouse, there is a “deemed sale” of the
property at its current market value at the time of transfer. This could
then trigger a capital gains tax to you (even though you didn’t actually
sell the property or receive any proceeds).
One of the most dangerous examples of this tax trap awaits Ontario
taxpayers (and those in some other provinces as well) who change the title
to their cottage from one person to joint tenancy in order to reduce
probate fees. The Canada Revenue Agency will treat this as a deemed sale of
the property at current values, to the extent that new co-tenants (other
than a spouse) come into the picture.
Suppose, for example, that you decide to put your home in co-tenancy with
your two kids. The CRA’s position is that you will have sold two
thirds of your property to your kids. Furthermore, since each child now
owns a third of the home, the availability of the principal residence
exemption for each one third interest will depend on the individual
circumstances of yourself and each child.
On some occasions, taxpayers who have unwittingly fallen into a
transfer/deemed sale trap have been able to convince the CRA that they held
the property “in trust” for their kids, i.e., that their kids have been
“beneficial owners” of the property all along. However, this can be an
uphill battle and must be supported not only by the particular
circumstances but also by proper documentation. For example, it is possible
that statements listing ownership of assets provided to a financial
institution could trip you up.
Renting out the second home
If you are concerned about triggering a capital gains tax by selling the
cottage, you may want to consider a scenario where your second home doubles
as a rental property. While rental income is potentially taxable, you are
entitled to claim applicable expenses (including any mortgage payments).
Often, these expenses can really mount up and may put you into an overall
loss position. If so, the losses are potentially available to shelter other
sources of income, be it from your job, or whatever. (If the second home is
a farm, there are usually restrictions on the amount of annual losses that
can be claimed, known as “restricted farm losses.”)
But for those who are tempted to pile up the writeoffs, a word of warning:
the CRA has been known to carefully monitor taxpayers who consistently
claim rental losses over a period of several years. It may well dispute
your claim based on the premise that there must be a reasonable expectation
of profit. However, this line of attack was generally shot down by the
Supreme Court of Canada in two landmark cases (Stewart and Wa lls), which drew an exception for properties
that involve an element of personal use. So, the CRA can and will still
Cottages south of the border
Other complications may arise if the second home is located outside of
Canada, particularly in the U.S.:
If you sell U.S. real estate, there is a U.S. withholding tax. The tax
withheld may be offset against U.S. tax payable on the capital gain.
Happily, there is no withholding if the sale price is less than US$300,000
and the purchaser intends to use the property as a principal residence.
However, the gain on the sale will still be taxable in the U.S., and you
will have to file a U.S. tax return. (It is also possible to go through
certain procedures to reduce the withholding.)
On a sale of your real estate, you will need to provide an Individual
Taxpayer Identity Number (“ITIN”) to the transfer agent. This is so, even
if no withholding tax is due. The sale cannot close without both the vendor
and purchaser providing an ITIN. In addition, the IRS will not issue a
receipt for the withholding tax paid unless both the vendor and purchaser
provide an ITIN. An ITIN can be obtained by filing Form W-7 with
the IRA. This is at least a six-week process.
If you sell your real estate, you will have to file a U.S. tax return to
report the gain (a credit may be claimed for tax withheld under FlRPTA).
This filing requirement is true even where there is no withholding tax due.
The capital gains tax rate in the U.S. is currently 15% (if owned
personally). If you have owned the property since before September 27,
1980, you can take advantage of the Canada/ U.S. Tax Treaty to reduce the
gain. In this case, you will have to pay tax only on the gain that accrued
since January 1, 1985 (this does not apply to business properties that are
part of a permanent establishment in the U.S.). To claim this treaty
benefit, you have to make the claim on your U.S. tax return and include
specific information about the sale.
Any U.S. tax paid on the sale of the property will generate a foreign tax
credit, which you can use to reduce your Canadian tax on the sale. Note:
This tax credit may be limited if you use your principal residence
exemption to reduce your Canadian gain.
Samantha Prasad, LL.B., is a Partner with Toronto law firm
Minden Gross LLP, a Meritas Law Firm Worldwide affiliate, and specializes in corporate,
estate, and international tax planning. She writes frequently on tax
issues, and is the co-editor of various
Wolters Kluwer Ltd. tax publications. Portions of this article first appeared in The TaxLetter, © 2017 by
MPL Communications Ltd. Used with permission.
© 2017 by Fund Library. All rights reserved. Reproduction in whole or in
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The foregoing is for general information purposes only and is the opinion
of the writer. This information is not intended to provide specific
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