Keep the Tax Auditor Out of Your Cottage
When you ‘critter-proof’ your cottage this fall, don’t leave any room for tax problems to creep in. There are many legitimate tax planning opportunities with second properties, but understanding the rules and keeping good records are critical to avoiding nasty messes in the future.
If you rent out your cottage:
Allowing others to enjoy your cottage when you don’t need it is a good way to build your equity faster. Track every expense associated with the cottage so that your accountant can help you maximize deductions. Don’t ignore potential deductions just because expenses exceed revenue; some items will not apply fully, and any negative rental income may provide tax reductions against employment or other income.
If you are selling the cottage:
If you’ve owned a cottage for a while you’ve likely have a substantial gain when you sell it (or transfer the ownership to another family member). If you invest a little time in planning and recordkeeping, you may be able to reduce the taxable portion substantially.
1. If you’ve owned the cottage for a very long time, then growth prior to 1972 is not taxable, but you need to be able to prove what the market value was on Dec 31, 1971.
2. The principle residence exemption can be used for the cottage instead of your house, but you will need to assess the tax implications for both properties. Get professional advice as soon as possible.
3. Municipal taxes and mortgage interest are NOT allowable factors when computing the taxable gain. They only provide deductions against rental income.
4. Selling the cottage to a family member for less than full market value will not save tax, it will actually lead to double taxation (see below).
If you would like to keep the cottage in the family:
Keeping a cottage in the family means keeping happy times alive, but you can’t keep postponing the tax. You can prepare for and minimize the tax impact but you need to invest some time in planning.
1. No matter how you transition the cottage (lifetime gift, sale or bequest) the tax implications to you are the same. You will be deemed to have disposed of it at fair market value, and you will owe tax on any gain.
2. Selling to a family member for a reduced price is the worst possible way to transition a taxable property. You will not avoid tax on the discounted portion, and the new owner will have to pay tax on both the future gain AND the amount you discounted the property. If you want to give away the cottage while alive, have all the paperwork reflect fair market value.
3. Allowing a family member to purchase the cottage from the estate for a discount leads to the same tax problems as above. There are other ways to structure this type of bequest.
4. There are numerous creative and tax-efficient ways to allow for long term family ownership, but the sooner you make these arrangements the better. You cannot backdate a good strategy, so every year you delay planning is a year of lost opportunity.
Consider these opportunities for maximizing your deductions (and check with your accountant if they apply to you):
1. Track mileage and meals for any cottage trips made to prepare for or clean up after renters.
2. Pay your spouse, kids (or grandkids) to help with maintenance.
3. Keep all receipts, for big jobs (such as renovations), little items (such as cleaning supplies) and everything in between (linens, furniture, etc.).
4. If you own the cottage outright but have a mortgage on your home, book a planning session with your accountant. There are many factors to consider but you may be able to make some of the interest deductible if you re-arrange your debt.