Principal Residence Exemption from Taxation of Cottages

The Cottage Purchasing Boom

With Canadians limited from foreign vacations and many Canadians working remotely over the past year due to the COVID-19 pandemic, there has been a boom in purchasing cottages and other recreational properties. Royal LePage, a major Canadian real estate franchiser and owner-operator, reported that within the first nine months of 2020 the price of recreational properties went up 11.5%. According to the Financial Post, the Township of Muskoka Lakes, Ont. – a popular location for high end cottages – saw cottages prices surge more than 70% since the pandemic began.

Some cottage buyers, including many retirees, have sold their previous homes, making these new properties their full time residences. Others have purchased these cottages as a domestic getaway spot while ongoing travel restrictions keep them from the sandy shores of the Caribbean. However, as Canadians rush to claim dock space, they should keep in mind the tax impact of these cottage purchases.

Tax Treatment of Selling a Cottage

When Canadians sell real property in Canada, such as houses, land, and cottages, there are three possible tax treatments which can be applied.

Principal Residence – The property is elected to be the individual’s principal residence. Any tax which would otherwise be payable on the sale of the property is decreased or eliminated based on the principal residence exemption calculation. If the property is claimed as a principal residence for all years it was owned, there is no tax payable on the sale of the property. This option will be discussed in greater detail below.

Capital Gain on Investment Income – The taxpayer is assumed to have purchased the property as an investment. Capital gains tax is paid on the sale of the property. This is calculated as the 50% of the following: sale price of the property, less the adjusted cost base of the property and certain expenses associated with the sale of the property. The adjusted cost base of the property may be increased by capital expenditures to the property during the period of ownership. If this calculation provides a negative value, the taxpayer has incurred a capital loss which can be used to offset other capital gains and reduce tax owed. This will also apply for properties which are used for personal, not business use, but not claimed as a principal residence.

Business Income – Taxpayers who engage with buying and selling real property as a business, even on a one-off basis, will typically be deemed to have earned business income on the sale of a cottage. The entire sale price of the property, less certain expenses associated with the sale of the property, is included in their income. These taxpayers may also have to charge GST/HST to the purchaser on the sale of the property.

Gifting and Bequests to Family Members

A taxpayer may choose to gift a cottage to family members, or have family members inherit the cottage upon the taxpayer’s death. Taxpayers who transfer capital property to a recipient who is not arm’s length from the taxpayer for less than fair market value consideration are deemed to have disposed of the property at fair market value. This will trigger a capital gain or capital loss for the taxpayer who is gifting the cottage, unless the cottage was claimed as the taxpayer’s principal residence.

When an individual passes away, there is a deemed disposition of the all individual’s capital property on death. Unless a cottage was claimed as the decedent’s principal residence, the estate will typically incur either a capital gain or capital loss on the property. Once the terminal return is prepared and all taxes of the estate are paid, the legal representative of the estate should apply for a tax clearance certificate.

Principal Residence Exemption

To assist Canadians in acquiring a home, the government introduced the “Principal Residence Exemption”. It allows Canadian taxpayers to decrease the amount of tax owed on the sale of their property. The principal residence exemption is calculated as:

((# of years the taxpayer is claiming the property as his or her principal residence + 1) x capital gain)divided by # of years the taxpayer owned the property

For taxpayers who live only in their cottage or another residential property, it is fairly straightforward that their cottage or residential property is their principal residence.

For taxpayers who split their time between their cottage and another home, the determination of the principal residence exemption can become more complicated. A property can be claimed as a taxpayer’s principal residence when that property is “ordinarily inhabited” by the taxpayer and/or his or her spouse or common-law partner during the period in which the principal residence exemption is claimed. “Ordinarily inhabited” is considered in the context of the type of property. Therefore, visiting a cottage a few times a year on vacation is considered to be “ordinarily inhabiting” the cottage. The cottage can be claimed as the taxpayer’s principal residence even if the taxpayer does not live at the cottage the majority of the year.

If the taxpayer owns two or more properties that could qualify as the taxpayer’s principal residence, there a tax planning determination needs to be made. Only one property can be designated as the principal residence for the taxpayer and his or her spouse/common-law partner in each year. However, taxpayers are free to choose whichever property they own to designate as their principal residence in each year, so long as each property qualifies as a principal residence. One property can be designated as their principal residence for one year, and another can be designated as the principal residence for the next year.

For example, Mark purchased a cottage in Muskoka and a house in Toronto in 2002. He and his family live in Toronto during the school year, but visit the cottage during March Break and the majority of the summer holiday. In 2020, Mark and his spouse become empty-nesters and decide to take advantage of the hot housing market to downsize their property holdings and earn some money. They sell the house and move full time to their cottage. Their experienced Canadian tax lawyer analyzes their circumstances and identifies they should claim the house as their principal residence for the overlapping 2002 to 2020 period as that would provide greater tax savings. When Mark and his spouse sell the cottage in 2030 to move into a retirement community, they can only claim the cottage as their principal residence for 2021 to 2030.

It should be noted, with some exceptions, only 1.25 acres of property can be considered part of the “principal residence”, so if you own a cottage with more acreage beyond 1.25, the remaining portion will normally be subject to tax on the capital gain when sold. However there are exceptions so consult with an experienced Canadian tax lawyer to determine if more acreage can be claimed as part of the principal residence exemption.

Change in Use

Taxpayers may choose to rent a cottage they formerly used entirely for personal enjoyment, or stop renting a cottage and use it entirely for personal enjoyment. Either of these situations could constitute what is known as a “change in use”. The taxpayer is changing the use of the cottage from rental to principal residence/personal use or vice versa.

Revisiting the example of Mark and his spouse, if they rented the cottage out when they moved to the retirement home in 2030 instead of selling the property, a “change in use” from principal residence to rental property would have occurred in 2030.

A “change in use” is a taxable event as it creates a deemed disposition of the property. If the taxpayer is moving the property from being a principal residence to a rental property, the principal residence exemption will offset the tax. If the taxpayer is taking a rental property and making it his or her principal residence or personal use property, the taxpayer can use the section 45(2) election to delay paying the tax related to this deemed disposition until the taxpayer either rescinds the election or sells the property.

Residing at the cottage for part of the year, and renting when the taxpayer is away from the cottage may impact the taxpayer’s ability to claim the principal residence exemption. These situations are highly fact dependent and taxpayers are advised to consult with one of our experienced Canadian tax lawyers to understand their tax obligations in these circumstances.

A brief note on foreign cottages and recreational properties, and foreign buyers

Though this article has focused on Canadian tax residents owning Canadian cottages, there may be Canadian tax residents who own recreational properties in other countries, such as the proverbial Miami condo, or individuals who are not Canadian tax residents who own Canadian cottages. This can create some additional reporting requirements.

Canadian tax residents can claim foreign property as their principal residence so long as they “ordinarily inhabit” the foreign property. These taxpayers may be liable for foreign taxes on the sale of that property regardless of whether they claim the property as their principal residence on their Canadian tax returns. If the property is not claimed as the taxpayer’s principal residence and foreign tax is due on the sale of the property, the taxpayer may be able to claim foreign tax credits in Canada based on the foreign tax paid. A tax treaty between Canada and the country in which the property is located may also render it so only the foreign country can tax the sale of the property. It should also be noted Canadian taxpayers who own foreign property worth collectively more than $100,000 CAD must file a T1135 form each year. However, personal use property does not need to be reported on the T1135.

Alternately, if an individual who is not a Canadian tax resident owns a Canadian cottage, any income earned from the property either by selling or renting the property must be reported in Canada and have Canadian tax paid on it. If the country the individual is a tax resident of has a tax treaty with Canada, there may be some variation to these rules.

International taxation issues are complicated and the resulting taxation can be dependent on where the taxpayer is resident and where the property is located. One of our experienced Canadian tax lawyers can assist taxpayers in understanding their tax obligations in these circumstances.

Pro Tax Tips: Denied Principal Residence Exemption

The Canada Revenue Agency (“CRA”) is well aware the principal residence exemption provides taxpayers with huge tax savings, and is therefore constantly trying to identify taxpayers who have improperly used the exemption. When the CRA finds a taxpayer it believes is improperly using the principal residence exemption, it will argue the income from the taxpayer’s sale of the property should have been taxed as a capital gain as investment income, or worse, fully taxable as business income. The CRA may also apply hefty gross negligence penalties.

The CRA can be overzealous in attempting to identify those taxpayers improperly using the principal residence exemption. Taxpayers who properly claimed the principal residence exemption may be audited or reassessed under the CRA’s position that these taxpayers improperly claimed the principal residence exemption. Taxpayers should keep records of their “ordinary habitation” of the property, especially if they only live at the property for a short time. Records may include utility bills, government identification with the property’s address, and mail received to the property. For taxpayers who only vacation at their cottages, finding records to keep can be much more complicated. Taxpayers facing a tax audit or tax reassessment of their principal residence exemption should therefore contact our experienced Canadian tax lawyers to assist in successfully navigating having the original principal residence exemption claim upheld.