For cottage owners looking to sell or gift their cottage, changes to the capital gains inclusion rates can have a significant impact on your tax bill. In our guide, Passing on the Cottage: A Guide for Families, Peter outlines the various methods of transferring your cottage to the next generation. While the focus of the Guide is maintaining family harmony while making sound financial decisions, in this piece I will delve into the nitty gritty of capital gains.
In this example we will focus on properties owned by individuals, where the gains are above the new $250,000 threshold, and are not being claimed as a principal residence. Remember – for cottages owned by a corporation or trust, all gains are taxed at the new 66.7% inclusion rate. Confusing, I know!
Here is a summary of the relevant changes:
Say you purchased your cottage in 1995 for $120,000, it is now worth $700,000, and you were debating passing it on to your children or selling it in the coming months. Selling it means the following:
| Proceeds | $700,000 |
| (less) cost | $120,000 |
| Gross Capital Gain | $580,000 |
| Taxable gain included at 50% (A) | $250,000 x 50% = $125,000 |
| Taxable gain included at 66.67% (B) | ($580,000 – $250,000) x 66.67% = $220,000 |
| Total Taxable Capital Gain (A+B) | $345,000 |
If instead you owned the cottage with your spouse 50/50, then you are each entitled the $250,000 threshold on the gain. This is what the situation looks like for each spouse
| 50% of Gross Capital Gain for each spouse | $580,000 x 50% = $290,000 |
| Taxable gain included at 50% | $250,000 x 50% = $125,000 |
| Taxable gain included at 66.67% | $40,000 x 66.67% = $26,667 |
| Total Taxable Capital Gain (per spouse) | $151,667 |
| Total Taxable Capital Gain for couple | $303,334 |
Owning with a spouse reduces total taxable income by $41,666, which translates to almost $20,000 in tax savings at the highest marginal rate in Quebec. What if you don’t have a spouse and want to pass the cottage on, or if you have a spouse who isn’t on the deed? Here are some options you can consider before the cottage passes through your estate, with varying degrees of effectiveness.
There are two ways you can gift the property to your spouse: either at cost, or at fair market value. If you gift a portion of the property to your spouse at cost, you will not have any tax consequences when you transfer and you will be able to split the gain when you sell/pass on the property. However, due to the attribution rules, the full gain will be included on the gifter’s tax return when the property is ultimately sold. You are no better off than when you started; don’t do this.
You can make a section 73(1) election to gift the property to your spouse at fair market value, as if you sold the property to them without any cash changing hands. The taxman, however, will be owed the taxes on the gain. The same outcome is accomplished by selling the portion to your spouse, for what it’s worth and not a penny more or less. When the property is gifted or sold at fair market value, the attribution rules no longer apply, and the gain is split proportionally between spouses when the cottage is ultimately passed on. Using a spousal loan works too, but has more moving parts and associated ongoing costs.
Gifting a portion of the property to your children crystallizes the gain on that potion, though unlike a gift to your spouse, there are no future attribution rules when the property is sold. However, you now have the wonderful web of joint tenancy, survivorship rights, or tenants in common to deal with. You will need clear legal documentation and coordination with your children to make this work.
You are ready to give it all away hoping your children will let you come for a swim in the lake (kidding, of course they will). You could make use of a capital gains reserve by selling the property to your kids over the course of at most 5 years, thereby splitting the gain over tax years. Careful – you must receive the cash from your children; promissory notes won’t do the trick, as was established in the case of The Queen v Derbecker (1984). There is the possibility of gifting or loaning money to your kids to have them then turn around and pay you for the property with the gifted money, or even to gift a portion of the property each year, but the CRA may see this as aggressive tax planning.
The General Anti-Avoidance Rule (GAAR) from the Income Tax Act previously stated that penalties could be imposed if transactions had the explicit goal of misusing the Income Tax Act to avoid or defer taxes. The most recent drafting has expanded the rule to include transaction(s) for which one of the main purposes is to receive a tax benefit and where the transaction(s) lack “economic substance”.
The whole point of this article is to provide ideas on how to use the provisions of the Canadian legal and tax landscape to help plan for our clients. As the new rules have been drafted and have received royal assent, what will unfold is not yet clear to us, nor is it to legal experts and the Canadian legal system. It may take years to build up enough jurisprudence to reveal the true spirit of the law, specifically with the new GAAR.
In all cases, as is oft repeated when financial planning, please consult a tax or legal professional before acting. We are in very new territory with costly consequences potentially lurking in the unexplored shadows of our legal system.
