INCOME TAX PLANNING

Perhaps the biggest tax problem associated with the vacation property is the potential for capital gains tax upon either the sale or gift of the property or upon the death of the owner.

If you sell or gift the property while you are alive, you will generally be taxed on the difference between the amount you receive (the "proceeds of disposition") and the adjusted cost base (ACB) or tax cost of the property. Note that it's important to keep receipts for all improvements and renovations made to the property, as these expenditures can be added to the ACB of the property, thus potentially reducing the amount of capital gain upon sale, gift or death.

The main exception to this general rule is if the property is gifted to a spouse or common-law partner, either during your lifetime or upon death. If that's the case, then the property is deemed to automatically "roll over" (i.e. be transferred) to the other spouse or partner at its ACB and no gain will be immediately reportable.

While many parents may wish to give the vacation property to their kids, either while they are alive, or upon death, doing so will result in an immediate capital gain if the property has gone up in value since the date of acquisition.

As a result, we need to explore some tax planning strategies to either permanently avoid the capital gains tax or, at the very least, to defer paying it as long as possible.

Principal residence exemption

The principal residence exemption ("PRE"), if available, can shelter the gain on a principal residence from capital gains tax. A principal residence can include a vacation property, even if it's not where you primarily live during the year as long as you "ordinarily inhabit" it at some point during the year.

A cottage is considered to be ordinarily inhabited by someone, even if that person lives in that property for only a short period of time during the year (e.g., during the summer months), as long as the main reason for owning the property is not for the purpose of earning income. Even if you rent it out occasionally, the CRA has stated that incidental rental income won't prevent a cottage from still qualifying as a principal residence.

Note that the home does not have to be located in Canada to qualify as a principal residence. The only requirement is that the individual who claims the PRE must be a resident of Canada for each year of claim. As a result, a U.S. vacation property, for example, owned by a Canadian resident may be eligible for designation as a principal residence for the purposes of claiming the PRE. Of course, whether or not it's advisable to do so will depend on both the income and estate tax considerations of the other country. (See "U.S. Vacation Properties" below).

Prior to 1982, it was possible for each spouse to own a property and designate it as his or her principal residence, with the resulting capital gains tax-free upon disposition. The change of rules means that for years of ownership after 1981, a couple can only designate one property between them as their principal residence for any particular calendar year.

This becomes a challenge when a couple owns more than one principal residence and is forced to choose, upon ultimate sale of the first one, which property will be designated the principal residence for each year during the period of multi-home ownership.

Technically, the calculation of the PRE is done on Form T2091-(IND), "Designation of a Property as a Principal Residence by an Individual." The CRA, however, assumes that if the Form isn't filed and no gain is reported on your return for the year of sale, the PRE has been used to eliminate the gain and therefore, no other property (such as the vacation property) can be designated for the years in which the PRE was presumed to be claimed on the sold property.

As a result, a conscious decision should be made when you sell one of your personal residential properties as to whether the gain should be reported since failure to report will result in the assumption that the "sold property" has been designated as your principal residence for the years you owned it, precluding you from using the PRE in the future on the sale of your other property, at least during the overlapping years.

Generally, the decision to claim the PRE when you sell your vacation property as opposed to "saving it" for the disposition of your other property will depend on a number of factors, including: the average annual gain on each property (i.e., the gain on each property divided by the number of years each was held), the potential for future increases (or decreases) in value of the unsold property and the anticipated holding period of the unsold property.
Non-economic factors may also come into play as you may be more concerned about a current, immediate tax liability today versus a tax liability payable later on (say upon death, by your estate) on the sale of your other property.

Return to Top

Life insurance

Although numerous planning ideas are available to reduce or defer tax liability on the transfer of the cottage, one of the most common is the use of life insurance.

You can purchase a life insurance policy to offset the tax liability upon death. Owners, however, often overestimate the amount and the cost of such insurance. As demonstrated in the following example to insure the potential tax on a half a million dollar gain, the cost can be less than $100 per month, depending on the age and health of the insured.

Take Drew, for example. He's 50, and owns a mountain chalet in Canmore, Alta. that he purchased for $400,000, which is now worth $900,000. He's sitting on an accrued gain of $500,000, of which only 50% is taxable. How much life insurance does he need to cover off the tax liability so he can pass the cottage on to his kids tax-free?

Using Alberta's top marginal tax rate of about 40%, Drew's current tax liability to be insured is $100,000 (40% of $250,000). The cost of a term-to-100 insurance policy varies by provider but averages about $1,100 a year if Drew is in good health.

Practically speaking, life insurance may not always be feasible. If the cottage owner is in his or her 70s or older, he or she may be uninsurable or the premiums prohibitively expensive.

Return to Top

Use of a corporation

It's generally not advisable to hold a personal residence inside a corporation. The main reason is that under the Income Tax Act, the value of the rent-free use of the corporation's residence by the shareholder is considered to be a taxable shareholder benefit and must be included in the owner's personal income. The value of the benefit will generally be equal to a market rate of return multiplied by the fair market value of the vacation property.

While it used to be commonplace for Canadian purchasers of U.S. vacation homes to purchase U.S. real estate through a Canadian corporation, referred to as a single-purpose corporation, a change in the CRA's administrative concession relating to this shareholder benefit issue effective in 2005 has put an end to this planning for the most part. (See below "U.S. vacation properties")

The other problem with a corporation holding the property is the inability to claim the PRE on the sale, gift or transfer of the property or the shares of the corporation.

Return to Top

Use of a trust

One of the most common alternate ways to own a vacation property is through a trust. This is often done to avoid the deemed disposition of the property upon the death of the owners. A trust is not a legal entity but rather a relationship that separates the legal ownership of property from the beneficial use and enjoyment of that property.

In a typical scenario, the property's current owner (the trust's "settlor") would settle the property with a "trustee," perhaps the owner's spouse or partner, for the benefit of their kids (the "beneficiaries.")

The problem with using a trust for a property you currently own is that a transfer of the property to a trust may trigger immediate capital gains tax. There are specific exceptions (such as a transfer to an "alter-ego trust," discussed below under the heading "Probate Planning").

On the other hand, if you are purchasing a new property or own one that has little or no accrued capital gains or even a loss, you may wish to purchase the property through the trust or transfer the existing property into a trust today so that any future capital gains tax that arises can be deferred until the trust's beneficiaries (generally the children) ultimately sell the property. (Note that a loss on a transfer of a residence to a trust is considered a loss from the sale of "personal use property" and cannot be claimed as a capital loss.)

The trust deed may permit you to enjoy the use of the property during your lifetime. Later on, when you find you are no longer using the property as much, it can be distributed from the trust to the appropriate beneficiaries.

When the property is distributed from the trust, it can generally be "rolled out" to the beneficiaries at the original ACB of the property, and thus tax would be deferred until the property is sold by the beneficiary. The beneficiary of the family trust who receives the property is deemed to have owned it since the trust acquired it for the purposes of claiming the PRE upon its ultimate sale. This allows a child who is the beneficiary of a trust that held the vacation property and who did not own another home while the property was in the trust, to use the PRE to potentially shelter the entire gain from the date of original purchase by the trust to the date the property is ultimately sold by the beneficiary.

Perhaps the biggest problem, however, stemming from using a trust to hold the vacation property is the "21-year rule." This rule states that there is a deemed disposition of the trust's property on each 21st anniversary of the trust, which could result in a capital gain on property held in the trust, accelerating the tax liability which otherwise may have been deferred until the last-to-die of the parents who originally owned the vacation property. Note that tax obligation occurring as a result of the 21 year rule can be avoided by distributing the property to the trust's beneficiaries within the 21 year period, as discussed above. The 21-year rule will create difficulties where the beneficiaries are too young to receive a share of the property within that timeframe.

While the trust may be able to claim the PRE to shelter the gain on this disposition, that may cause problems if the children who are beneficiaries of the trust also own their own homes as it would preclude them from using the PRE to shelter a gain from the sale of those homes. Similarly, if a beneficiary has used the PRE on another property, the trust cannot designate the property as a principal residence for those years.

In addition to tax planning, properly structured trusts can also be used for other non-tax reasons, such as avoiding a possible claim under British Columbia's Wills Variation Act, protecting assets from creditors as well as minimizing provincial probate tax, as will be discussed below.

Return to Top

Next tip >

Disclaimer:
As with all planning strategies, you should seek the advice of a qualified financial advisor or tax advisor to discuss planning opportunities for recreational properties.

Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto. As a member of the CIBC Retail Markets team, Jamie works closely with advisors from CIBC Private Wealth Management, Wood Gundy, Imperial Service and other partners to support their high net worth clients and deliver integrated financial planning and comprehensive advisory solutions. Jamie writes a weekly column called "Tax Expert" in the National Post, which is also syndicated across various CanWest newspapers in Canada. In his spare time, Jamie teaches an MBA course in personal finance at the Schulich School of Business at York University in Toronto.