Dave Sidaway, the Gazette
Most cottage properties appreciate, and capital gains tax is a factor when passing them on to the next generation.
Marty and Eleanor are having a wonderful retirement. They have taken up golf, go to theatre, entertain and travel extensively. But they find they are spending less time at their country cottage -- the place they so enjoyed as the children were growing up.
Fortunately, their two children who are now raising families of their own are making good use of the place. It seems to be occupied all summer long and on most winter weekends. The children are doing a wonderful job maintaining the property, which is a source of pride to Eleanor as it has been in her family for close to 75 years.
Marty and Eleanor have been thinking it might be time to give the cottage to the children. After all, they planned to bequeath it to them on death. Why wait -- the kids treat it like their own and it will be one less thing to deal with in the will.
Sounds simple, doesn't it?
But, not only is it far from simple -- it may be heavily taxable. A cottage is a capital property, and that means any profit on its disposition is a capital gain. A disposition can be an outright sale, an inter-vivos gift, a deemed disposition on death and even a deemed disposition on a change of use.
A gift of property to a child, even an adult child, is considered by Revenue Canada to be a "sale" at the property's fair market value.
Although gains on the sale or disposition of personal property are taxable, losses from most personal property are denied for tax purposes.
Fortunately, in the case of a cottage, some or all of the accrued gain can be sheltered from tax using the principal residence exemption. This is done by designating the cottage as a principal residence for a selected number of years of ownership.
A principal residence can be a house, a condominium, cottage and even a mobile home or trailer that ordinarily is inhabited by the owner, the owner's spouse or the owner's children. According to Revenue Canada, seasonal occupation is sufficient to be considered ordinarily inhabited. The property can be owned alone or jointly. Property outside Canada can be considered a principal residence.
Vacant land cannot be considered a principal residence. If a family buys a piece of land with the intention of building on it, the property will only be eligible for principal-residence status after a dwelling has been built and is in use.
You may designate only one property as a principal residence for a particular year. In addition, for years after 1981, a property can only be designated as a principal residence if no other property has been so designated during that year by your family unit -- which includes you, your spouse or your minor children.
This means every family member can designate one eligible property as a principal residence for years up to and including 1981. But in 1982 and thereafter, only one property may be designated per family unit for any one year. If only one home was owned after 1981, the rule change is of no consequence. The principal residence designation on that home will be available to shelter the entire capital gain realized on that property. But if two homes -- say, a city home and a cottage -- were owned after that year, tax will be payable for post-1981 gains relating to years for which one of the dwellings was not designated a principal residence.
The principal-residence designation only becomes a concern when one of the properties is sold or otherwise disposed of at a profit. In the tax return for that year, form T2091 may be used to make the designation and to compute the principal-residence exemption. However, Revenue Canada has indicated the form need not be filed if the principal-residence exemption completely eliminates the capital gain on the property.
Remember, if no form is filed it doesn't mean those years of ownership still are available to use as principal-residence years on a subsequent disposition.
So how is the gain on a principal residence computed? First you compute the actual gain in the ordinary manner (proceeds less cost). For properties that were owned continuously since 1972 -- when capital gains taxation began -- it is the value on Dec. 31, 1971, that generally is used as the cost base. Renovations or additions during the period of ownership should also be added to the cost.
The actual gain is then reduced by the proportion of the gain that is one plus the number of years the property is being designated as a principal residence over the total number of years of ownership. Note that only years after 1971 are counted in this formula, and you cannot use years in which you previously had designated another home as your principal residence (or, after 1981, designated by your spouse or minor children).
In addition, where the cottage includes a substantial amount of land, the entire property may not be considered to be a principal residence. Revenue Canada says that, generally, a principal residence can only include adjoining land of up to one-half of a hectare (about 1.2 acres).
However, if the home is on a property that is governed by zoning restrictions that require minimum lot sizes, or if there are severance restrictions, a larger area or even the entire property may be considered part of the value of the principal residence.
If you own a principal-residence property that you acquired prior to 1982, there is a special rule to consider. Pre-1982 and post-1981 gains are computed separately (using the formula mentioned above) as though there was a disposition on Dec. 31, 1981 and a reacquisition. The principal-residence exemption is then computed and applied separately to each of these gains.
However, for the post-1981 period, when using the formula, you do not add one to number of years designated. If the resulting net gain is less than what you would have computed using the regular rule, this special rule will apply. Note that, under this rule, any post-1981 losses will reduce the maximum net gain that is to be reported.
As if the above rules and calculations weren't complex enough, there is an additional factor that you might have to include in your computations. In 1994, when the general $100,000 lifetime capital gains exemption was eliminated, taxpayers were given a final opportunity to use any remaining exemption by electing to have a deemed disposition on any property owned at the time.
Many individuals who had not used up their entire $100,000 exemption made this election for their cottages, knowing that they would only be able to shelter post-1981 gains for one of their residential properties. If the election was made for a cottage, the elected gain will reduce the reported capital gain on an actual or deemed disposition after applying the principal residence exemption.
If you allocated principal-residence years when making the 1994 election, those years cannot be changed at the time of disposition, although additional years can be designated. In certain cases, you might have to recalculate the amount of the 1994 election.
GIFTING A COTTAGE : A CASE STUDY
Calculation 1. Marty and Eleanor purchased their city house in 1967 for $82,000. Its value on Dec. 31, 1971, was $94,000. It rose to $260,000 on Dec. 31, 1981 and today, it is worth $540,000. Eleanor inherited her family's cottage in 1975 when it was worth $42,000. They spent $10,000 on an addition to the cottage in 1980. Its value on Dec. 31, 1981, was $91,000, and it now is worth $205,000. The city home is in Marty's name and the cottage is in Eleanor's name. They have not owned any other residences since 1972. There was no capital gains exemption election made for either property in 1994 tax returns.
Calculation 2. Because Marty and Eleanor can each designate a property as a principal residence for years before 1982, the home would be allocated 10 years of designation (1972-1981), and the cottage seven years (1975 to 1981). For the years after 1981, the gain per year on the home (under both the regular method and the alternative method) is significantly larger than the gain per year on the cottage. Therefore, initially, it makes sense to save the principal residence designation for 1982 through 1999 for the city home. But since the formula is based on one plus the number of years designated, at least one year should be designated to the cottage. On this basis, the capital gain on the cottage in respect of the gift to be made in 1999 will be calculated as in table 3.
Calculation 3. If Marty and Eleanor save principal-residence years to eliminate any potential gain on the sale of the city home, they will pay $36,720 of tax in 2000 as a result of gifting the cottage. Instead, they can eliminate the current gain and related tax by designating principal-residence years to the cottage. Although this will result in a larger absolute tax liability, the deferral benefit (the tax due on the disposition of home may be many years down the road), might outweigh the additional tax. To eliminate the gain on the disposition of the cottage, Mary and Eleanor would have to designate an additional 16 years for the cottage. Sixteen years of gain on the home is equal to 16 X $15,556, or $248,889. (This assumes alternate calculation would apply as the post-1981 gain per year is smaller that the pre-1982 gain per year.)
The related tax would be $93,333 (this assumes that the gain per year after 1999 will approximate the gain per year from 1982 to 1999. If we assume an after-tax rate of return of 5%, it would take about 19.5 years for $36,720 to grow to $93,333. That means that if Marty and Eleanor hold on to the city house for more that 19.5 years, they are better off using the principal residence exemption to shelter the tax on the cottage in 1999.
But there are numerous variables that must be considered: future tax rates, future property values, future holding period for property (there is a deemed dispositon of property on death at fair market value, except where property is transferred to a surviving spouse.)
Table 1 City house Cottage
Gain per year (initial calculation)
1999 value $540,000 $205,000
Adjusted cost base - 94,0001 - 52,0002
Gain 446,000 153,000
Number of years owned 283 253
Gain per year 15,929 6,120
Table 2 City house Cottage
Gain per year (alternate calculation)
Pre-1982 gains
Dec. 81 value $260,000 $91,000
Adjust cost base - 94,000 - 52,000
166,000 39,000
Number of years owned 10 yr 7 yr
Gain per year 16,600 5,571
Post-1981 gains
Current value 540,000 205,000
Dec. 1981 value - 260,000 - 91,000
280,000 114,000
Number of years owned 18yr 18yr
Gain per year 15,556 6,333
The principal residence decision
Gain otherwise computed $153,000
(in initial calculation above)
Table 3
Principal residence - 55,080
exemption4
Capital gain 97,920
Taxable capital gain 73,440
Tax @50% 36,720
1 Dec. 31, 1971 value 2 Includes addition to property 3 Only includes post-1971 years 4 Years designated: 1975 to 1981, plus one post-1981 year, plus 1, divided by years owned (25).
Source: Ernst & Young LLP
Gena Katz, CA, is a senior principal with Ernst & Young LLP's tax practice. Michel Lanteigne, FCA, the firm's national director of tax, also contributed to the article.