Tax changes anticipated. Plan now or pay more.

Changes to tax legislation are likely coming, and there will never be a better time to tax plan than right now under the current rules. With Canada’s net debt eclipsing $1 trillion all signs point towards an increase in the capital gains inclusion rate. Most tax and financial planners are also expecting changes to the Principal Residence Exemption (which may limit the gain exempt or tighten the rules so it doesn’t apply to your cottage).

Currently, the capital gains inclusion rate is 50%. This means 50% of the capital gain must be included in your taxable income and tax paid at your marginal rate. By increasing the inclusion rate the government could generate significant revenue to help reduce the deficit – a tactic the Canadian government has implemented in the past, when the inclusion rate went to 75% in 1990. In the US, President Biden has proposed treating capital gains as ordinary income for high income tax payers which would amount to 100% inclusion rate.

Compare the tax effects in the following scenario: You purchased your cottage 10 years ago for $100,000, failed to keep track of any improvements, and are now selling the cottage for $500,000. See table here

The last column denotes the taxes owing if the cottage owner were to use their Principal Residence Exemption (“PRE”).

Generally, if you or your spouse/common-law partner have resided at the cottage for a vacation period in any year, you may designate the cottage your principal residence for that year. However, only one residence may be designated as the Principal Residence in any given year per family unit.

Before determining whether to use the PRE on the home or cottage calculate the gain on each and claim the PRE on the property that has experienced a larger gain. Consult your accountant or tax lawyer for help.

If your cottage has greater gain, transfer the cottage to the next generation, use your PRE and pay no tax on the cottage now when the rules are simple and be able to access more PRE years on your house in the future.

Any sale, gift or transfer upon death to a non arm’s length party is deemed to occur at fair market value. With the expected changes, it is far better to transfer the title now and pay less tax.

If you previously sold a residence and did not report the gain, you are deemed to have used your PRE on that sale and can not claim the PRE on another property for the years in which you owned the property you sold. If your residence has increased in value more than your cottage, you may not wish to use your capital gains exemption on the cottage. If selling the cottage will result in a capital gains tax, it is better to pay at a 50% inclusion than 75% or higher.

For example, Elizabeth and Philip bought the cottage in 1990 for $100,000.00. Fair Market Value is now $400,000.00. They have visited the cottage every year. They sold various houses from 1990 – 2015 and are deemed to have used their PRE on each sale as they did not report any sale to CRA. They sold a home in 2020 and reported the gain and claimed the PRE. (Since 2016 you must report and claim the PRE). Therefore, they can only claim the PRE on the cottage for (2021 plus 1 extra year) 2 years out of the 31 years they have owned it or 6.45% tax free.

What if you are not ready to give up control of the cottage? Transfer a remainder interest either to your children or skip a generation and transfer to your adult grandchildren, keeping a life interest which gives you use and control during your life. As the life interest holder, you will be responsible for all taxes, insurance, and normal maintenance. While the remainder interest holders cannot interfere with the life tenants right of use during your lifetime, they will receive the benefit of any increase in value after transfer and you have deferred further tax on the cottage for a prolonged period of time. The time to cottage succession plan is now.

The information contained is provided for informational purposes only. Mona and Stéphane at PKF Lawyers would be pleased to provide additional advice for your specific circumstances.