Article

Cottages: Don’t Drop the Ball on Capital Gains

by John Poyser

Yes, it is early to think about cottage country as we celebrate the new year, but not for tax purposes. Now is the perfect time to discuss succession planning for 2007 as it relates to real estate if it is your intention to make ownership changes this year. Explaining the capital gains rules to your clients can be easy, but it must be in simple terms to enable the correct results. Here is a scenario to help you:

Jack and Elly have a cottage. They are selling their house in town and moving into an apartment, and plan to keep the cottage in the family to give to the kids.

Worried about capital gains, they see an advisor. The advisor calculates the capital gains tax payable on their house in the city as $35,000. The capital gains tax payable on the cottage is far higher, in the neighborhood of $75,000.

When a couple owns both a cottage and a home, they have a single principal residence exemption that can be used to shelter one of the two properties from capital gains taxes. Given the level of taxes pent up in the two properties, it will make sense for Jack and Elly to choose the cottage as their principal residence.

Two pieces of advice become important if you might be in the same shoes as Jack and Elly. First, keep all of the receipts for capital improvements on both the house and the cottage. If you ultimately select the cottage to be your principal residence, you will want to have the receipts for the house. That is because you will be paying capital gains taxes on the house, and will want to be able to justify a high “adjusted cost base” on that property. The receipts help you justify that higher cost base and minimize capital gains taxes.

Second, delay can be fatal. If you sell the house, or the cottage for that matter, you have to select one or the other to be your principal residence in that year. You cannot delay in making that designation. If you do delay, the tax people will effectively make the designation for you, and it may not be the one that makes the most sense for tax proposes. Thus, if you sell your house and fail to designate the cottage in that year, you may discover later that you are precluded from using the principal residence exemption to shelter capital gains on the cottage for the period of time that you owned the house. Instead, designate the cottage when you file your next income tax return after selling the house and pay the capital gains taxes.

Jack and Elly had no idea. They have not been keeping receipts for the house, only the cottage. They would never have thought to disclose a gain and pay capital gains on the sale of their house. Failing to do so would amount to a mistake, embracing the bigger tax bill later by overlooking the smaller tax bill now.

After the house is sold, Jack and Elly are thinking of transferring the cottage to their three children. The transfer would take place next year and each child would have a one third interest. In the right circumstances, there might be some good reasons for Jack and Elly to do that, but none of those reasons relates to capital gains. Currently, each child has a house of their own, and a principal residence exemption they can use. The parents retain their principal residence exemption for gains on the cottage. That equates to four parcels of land, four principal residence exemptions, and no capital gains taxes. Good math.

If the cottage is transferred to the three children, it creates three parcels of land. Add in the three houses the children already own. That equates to six parcels of land, three principal residence exemptions, and potential capital gains taxes that could have been avoided on some of those properties. Bad math.

A person need only spend a few weeks a year vacationing at the cottage for it to be eligible. A condo in Arizona can also qualify, or a houseboat in France, or even a RV. When it comes to land, the maximum surface area that can be protected is generally 1.23 acres.

Jack and Elly are fictional but their problems are real. Dozens of clients consult me each year in the same boat – some too late. You can’t protect yourself from taxes or build a good cottage succession plan unless you start with solid and specific answers relating to capital gains taxes and the principal residence exemption.

John E. S. Poyser is a lawyer with the Wealth and Succession Practice Group at the Winnipeg firm Inkster, Christie, Hughes and the author of two certificate courses with The Knowledge Bureau: Death of a Taxpayer and Use of Trusts in Tax and Estate Planning. For more information contact The Knowledge Bureau at 1-866-953-4769.

This information is used with the permission of Knowledge Bureau, Inc. For more information go to www.knowledgebureau.com.