This blog post was written by: Derek Hambly, Estate and Trust Consultant, Scotiatrust London

It is that time of year again when cottages, cabins and recreational properties are top of mind. Sitting in traffic getting out of town to get to the lake doesn’t seem so bad when your home-away-from-home is waiting for you…. unless of course you are worrying about the capital gain that has accrued on that property and you find yourself wondering just how you, or your heirs, are going to handle it.

In the usual course, when cottage properties pass between spouses either by rights of survivorship, qualified spousal trust, or through a spousal rollover, a capital gain is not realized. While it is true that a surviving spouse can choose to realize the capital gain at the passing of their spouse, it is unusual. The usual course is for capital gains to be triggered by the death of the second spouse and last surviving joint tenant. So, what can you do now or what discretion can you afford your heirs to do later to avoid, reduce or manage the impending capital gain on the cottage property.

To clarify, a capital gain is the increase in value of a property from its purchase price to its disposition value. As it stands the taxable capital gains inclusion rate, which is the portion of the gain that is included on your tax return as taxable income, stands at 50%. Earlier this year, the federal government announced that it is deferring the date on which the capital gains inclusion rate would increase from one-half to two-thirds until January 1, 2026. Keep in mind that was a different government during a rather tumultuous economic climate. Whether or not the inclusion rate on capital gains realized annually above $250,000 will increase to two-thirds is far from certain. In any case the government confirmed that the one great shelter from capital gains, the principal residence exemption, is still in place. Additionally, a new $250,000 annual threshold for capital gains would mean that an individual selling or transferring a cottage with a $500,000 capital gain would not pay any additional tax. It is also uncertain whether or not this will come into effect as well. This would be a welcomed change for those of us seeking tax minimizing strategies for clients.

Notwithstanding the potential changes, this article on minimizing the capital gains realized on the disposition of a cottage property is disappointingly short. In short, if your cottage does not double as a qualified farm or fishing property, avoiding capital gains entirely can only really be done by declaring the cottage as your principal residence. An individual can designate one real property as their principal residence and the growth in value of that property while it is the principal residence is not included as income on the individuals tax return after the sale or transfer of the property. The good news is that CRA does not specify an exact duration of time an individual or their family members, including a spouse, common-law partner or children, must reside in a dwelling for it to qualify as a principal residence for a given year (but keep in mind that you may not be able to claim principal residence exemption if the camp was used to generate rental income). The bad news is that for married or common law couples, there can be only one principal residence between the spouses or partners. You cannot, for example, claim the principal residence exemption on your house and your spouse or partner claim the exemption on the cottage. In order to realize the personal residence exemption it is important to remember to report the sale of the property on your tax return (Form T2091(IND), Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust).

In the majority of circumstances, the principal residence exemption is the only capital gain shelter however it is possible to reduce the capital gains that are taxable can be done by increasing the adjusted cost base of the cottage by making capital improvements to the property. “Capital improvements” are considered any projects or renovations that improve the cottage rather than simply restoring the cottage to a previous state of repair. The cost of a capital improvement can be added to the adjusted cost base when calculating the capital gain. Some examples of capital improvements that qualify include:

• Replacing a roof, broken fixtures, fixing plumbing, or replacing damaged flooring;
• Constructing an addition or an additional room, finishing a basement, building a new deck or dock, or expanding a deck or dock;
• Installing higher quality or more energy efficient doors, windows, flooring, panelling, or lighting; or
• Improvements to the surrounding property including an upgraded septic system, digging a well, building a driveway, or fixing a drainage problem.

Regalrdless of the what the update or renovation may be, it is important to keep all records and receipts for the materials, labour and contracting costs.  CRA may require that you substantiate your capital improvement claims with such receipts. If you are handy enough to have performed certain capital improvements yourself unfortunately you cannot include the cost of your own labour in the capital improvement calculation however you can include the cost of materials.

So, while regular care and maintenance does not qualify as capital improvements for capital gains purposes perhaps the new roof or deck might be just the thing to start the process of managing the eventual capital gain. Or at least it’s something to think about while you sit in traffic on the way to the cottage.

This is the first part of a two-part post regarding cottage tax and sucession planning. The next post will discuss insurance planning, and trust planning.