Docks, sunsets, and tax traps

The CRA wants to crash your piece of paradise

Cottages and cabins in the woods or by the lake are an iconic Canadian getaway. Most owners of recreational property happily deal with maintenance issues for the chance of that glorious sunset, water-skiing, or a dip in the lake. What they don’t count on is that silent partner, waiting to take their cut when it comes time to sell or transfer the place to their kids. Here’s what you need to know.

The tax trouble arises because your recreational property usually isn’t deemed to be your “principal residence” for tax purposes. A “principal residence” is the place where you live most of the time, and is thus exempt from capital gains tax when you sell. But most families can have only one principal residence. So when you sell your cottage, you’ll pay capital gains tax on an appreciation in the value of the property from the time you purchased it. It calculates the capital gain as the proceeds of the sale minus the cost of selling and the adjusted cost base (ACB). But it may be possible to cut the tax take by paying close attention to the “adjusted cost base.”

Calculating the ACB

Here’s what the CRA is most likely to accept in your calculation of adjusted cost base.

Costs of acquisition. The original purchase price or some proof of value if the property was a gift or inheritance. Other costs of acquisition include legal and inspection fees, land transfer taxes, sales commissions, survey, title insurance, and repairs to upgrade a property that was in disrepair, but you’ll have to prove that the original purchase price would have been higher without these repairs.

Other property improvements. Water systems, wells, septic or holding tanks, property drainage improvements, fixed decks and docks, and access driveway can all be included in the ACB if they are “new” and not a result of ongoing maintenance.

Qualifying renovations, if these weren’t part of the cottage before. For example, a bathroom (and all the fixtures), or a new deck, or even a couple of new bedrooms that expanded the size of the cottage would likely be accepted in the ACB.

All in the family

If you’ve inherited the family cottage – a situation that many families now find themselves in – you or your parents or grandparents may have been able to take advantage of something called “Valuation Day,” January 1, 1972, which involved assigning an acceptable value to the property as of that date. Essentially, any capital gain before that date will not be subject to capital gains tax. The V-day value (less improvements made since then) for these types of properties is considered to be the adjusted cost base for determining capital gains tax. That could still be significant, even if you can whittle down the adjusted cost base with capital improvements made over the intervening 40 years.

Transferring the title of the recreational property to your kids or grandkids, or holding title in joint tenancy, cannot be used to circumvent the tax bill. The CRA will still treat any such transfer as a deemed sale, and demand you pay capital gains tax.

Some owners try to keep a cottage in the family without incurring a deemed sale by holding the property “in trust.” But you actually have to create a trust for this purpose and go through all the legal procedures to make this happen. The CRA is highly skeptical of claims for recreational properties held “in trust” where no legal trust exists. So if you want to create a trust, you’re going to need expert legal help.

Rather than jumping through these hoops, many cottage owners simply purchase life insurance to cover the tax on the deemed sale of the property on the death of the owner. Here again, you’re going to need some knowledgeable financial help, because it’s easy to buy too much insurance.

Paradise lost

Recreational properties can have hidden tax implications when it comes time to sell or transfer the property to children. So if it’s time to take steps to sell or transfer the recreational property, consult a qualified financial professional who can help you avoid or mitigate the many legal and tax pitfalls that can turn your cozy cabin by the lake into a tax trap with a view.

Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation.

Notes and Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned are illustrative only and carry risk of loss. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.