So you want to buy a vacation home. You’re looking at properties, envisioning yourself out on the lake, and preparing yourself for a lifetime’s worth of cookouts, family gatherings, and . . . taxes?
Yes, while you may see your cottage as an idyllic getaway from the concerns of the outside world, there are moments when the outside world will barge in anyway — particularly during tax season. So while it’s tempting to focus your attention on boat rides and sunsets, ignoring the red tape involved in your new purchase, the best way to actually minimize your administrative tasks is to consider them early and get them under control.
Fortunately, Prashant Patel, RBC’s Vice President of Wealth Management Services, shared with us what he thinks are some of the relevant tax issues vacation-home buyers should be thinking about. Here are a few things you may want consider about your cottage property (besides how great it feels to kick back there on a midsummer evening).
Capital gains taxes will likely affect you at some point
For some cottage owners, capital gains tax can come as a shock. This tax is incurred when you sell property for more than you bought it for, or upon your death — and since most properties increase in value over time, it will likely affect you. “When you’re buying [a cottage], you’re not thinking of selling it,” says Patel. “But keep it in mind because during your ownership there are things you can do to help minimize capital gains tax down the road, whether it’s when you sell it or upon passing.”
But there are ways to minimize your capital gains tax
Patel notes that there are steps you can take to make capital gains tax less of a shock. One is to make investments in the property that will offset the gains.
Capital gains tax is calculated based on how much your property’s value has increased over the cost base, or what you paid for it. But some improvements you make to property can actually increase your cost base, therefore reducing the amount of capital gains. For example, Patel says, replacing the roof or adding a deck can increase your cost base, which in turn minimizes your capital gains tax.
Another step property owners can take to make capital gains tax less painful is to invest in life insurance that can be used to pay for the capital gains tax upon death. If you’re planning to leave the cottage to your kids, you can even strike a deal. “Some parents say, ‘kids you guys pay the premiums because you’re going to get the cottage,'” Patel says.
Your principal residence is exempt from capital gains tax
Under current tax rules, each family in Canada gets to claim one principal residence, and when they sell it, they do not have to pay capital gains tax on it. “Most people think only their city home is their principal residence, but CRA does allow a seasonal cottage to be your principal residence,” Patel says. “That’s advantageous because it’s possible that your cottage might have much larger gains than your city home.” So if your cottage has a larger gain compared to your city home, you may want to think about making your cottage your principal residence (provided it meets certain requirements) at the time of sale.
Your tax deductions can depend on whether you rent out your property
Patel notes that some people may buy a vacation property only to decide that they’re going to rent it out, making it a rental property rather than a vacation home for themselves. “The benefit there is you can start deducting your expenses against the rental income you’re getting — so interest on a mortgage, property taxes, utilities, and expenses like that,” he says. However, if you’re renting your property out for part of the year and using it yourself the rest of the time, it gets a little more tricky. You can still make some deductions, but it will depend on how much you rent the property out. Also, Patel notes, if the property is primarily used for rental, you may lose the option of claiming it as your principal residence for all years, so you should consider all aspects of renting out your property before you do it.
You may have to pay a probate tax
Probate taxes are basically like administrative taxes that come into effect when you pass away, Patel says, and each province has its own probate. However, probate tax is only incurred on your cottage if it passes through your estate. If you put it into joint tenancy with other family members while you’re still alive, probate tax will not be incurred until the death of the last tenant. You can also put the cottage in a family trust. There are pros and cons to these approaches, Patel says. His recommendation? Learn about what joint tenancy and a family trust means, and have a thorough conversation with anyone you want to enter into it with, ensuring you’ve thought through all the implications. “There’s no one strategy that fits all situations,” says Patel.
You may need outside help
It’s important to educate yourself as much as you can about tax issues, but it’s also a good idea to get the help of someone who knows all the ins and outs of tax law. “Work with a good accountant or lawyer. They would definitely be the ones to give the formal tax and legal advice,” says Patel.
In short, when you’re seeking advice, cast your net wide, and listen carefully to the advice of professionals. They’ve seen it all (taxed) before.
To learn more about planning your cottage estate, visit rbcwealthmanagement.com.