The Cottage as a Principal Residence

The following article appeared in the latest edition of the Hamilton Law Association Law Journal.

In many families, the summer cottage is something like an institution. It provides happy memories of lazy days spent on the water and cool nights with only the crickets to disturb one’s sleep. A cottage, however, can also present a tax problem. We are regularly consulted by taxpayers concerned about how their estates will pay the Canada Revenue Agency (the “CRA”) when it comes calling about the cottage after the death of its owner.

Deemed Disposition

A cottage, of course, is capital property for tax purposes. Accordingly, when an owner of a cottage dies, he or she is deemed to dispose of the property for tax purposes for proceeds equal to the fair market value of the cottage. If the proceeds deemed to be realized exceed the tax cost of the property to the person, the taxpayer will realize a capital gain equal to the excess, one-half of which must be included in income in the person’s “terminal return”.

The resulting tax bill can be quite large. I am told that the cottage property market has cooled somewhat over the last year or so, but that still leaves cottage property prices much higher than they were just ten years ago. An owner who bought a cottage for tens of thousands a generation or so ago might find himself owning real estate worth hundreds of thousands or even millions today. The owner, however, is not necessarily very wealthy, if one ignores the value of his cottage, and so the property taxes and the income taxes payable on death pose a significant problem. For some owners, without some form of tax planning, the only way they will be able to afford to pay the income taxes arising from the deemed disposition of the cottage will be to sell it.

The Principal Residence Exemption

The goods news is that the principal residence exemption might be available to help. In the words of CRA IT-120R6 (“Principal Residence”), the exemption “can eliminate or reduce (for income tax purposes) a capital gain on the disposition of a taxpayer’s principal residence.”

What is a “principal residence”? The Income Tax Act (Canada) (the “Act”) provides a rather detailed definition because it attempts to address a number of different types of ownership and use, including home ownership through co-ops and personal trusts. For the purposes of this article, it will be assumed that the taxpayer concerned owns a cottage in fee simple. The Act provides that a principal residence “of [such] a taxpayer for a taxation year” is a “housing unit […] that is owned, whether jointly with another person or otherwise, in the year by the taxpayer”.

“Housing unit” is not defined in the Act, but the CRA interprets the phrase as indicating that the exemption cannot be claimed in respect of raw land, presumably even if the raw land is ordinarily inhabited by a taxpayer who lives in a tent.

In addition, the definition makes it clear that only the owners of a residence can designate the property as a principal residence eligible for the exemption.

The definition does not require the housing unit to be located in Canada.

The definition goes on to provide that the property in question must be “ordinarily inhabited in the year by the taxpayer, by the taxpayer’s spouse or common-law partner or former spouse or common-law partner or by a child of the taxpayer”. In general, an individual cannot claim the exemption in respect of property he or she owns that is ordinarily inhabited by the individual’s parents (and no one else).

The CRA has been generous with its interpretation of the meaning of “ordinarily inhabited”:

The question of whether a housing unit is ordinarily inhabited in the year by a person must be resolved on the basis of the facts in each particular case. Even if a person inhabits a housing unit only for a short period of time in the year, this is sufficient for the housing unit to be considered “ordinarily inhabited in the year” by that person. […] [F]or example, a seasonal residence can be considered to be ordinarily inhabited in the year by a person who occupies it only during his or her vacation, provided that the main reason for owning the property is not to gain or produce income. With regard to the latter stipulation, a person receiving only incidental rental income from a seasonal residence is not considered to own the property mainly for the purpose of gaining or producing income.

A cottage, then, can qualify as a principal residence, even if it is occupied for only a relatively short period of time each year.

The definition of “principal residence” also provides that a property cannot be a principal residence in a taxation year unless it is designated as such by the taxpayer for the year. Moreover, a taxpayer can designate only one property per year as the taxpayer’s principal residence (for taxation years before 1982) and only one property with his or her spouse for years after 1981. Before 1982, individuals married to each other could each designate a property as a principal residence. After 1982, if one spouse designates a property, then the other cannot designate another one. The other spouse must designate the same property.

A taxpayer must designate a principal residence for each taxation year, but the designation need not be made in the year. Section 2301 of the Income Tax Regulations provides that the designation must be made for all years in respect of which the exemption is being claimed in the taxpayer’s return for the year in which the taxpayer sells the property. The CRA, however, does not even require the designation to be filed if the exemption completely eliminates any gain that would otherwise be realized on the disposition of the property. Practically speaking, then, a taxpayer must make a decision about whether to claim the exemption and on which property only when selling a property.

Finally, the Act provides that

the principal residence of a taxpayer for a taxation year shall be deemed to include […] the land subjacent to the housing unit and such portion of any immediately contiguous land as can reasonably be regarded as contributing to the use and enjoyment of the housing unit as a residence, except that where the total area of the subjacent land and of that portion exceeds ½ hectare, the excess shall be deemed not to have contributed to the use and enjoyment of the housing unit as a residence unless the taxpayer establishes that it was necessary to such use and enjoyment.

The question of how much land can be considered part of a taxpayer’s residence for the purposes of the exemption can be quite important for cottage properties. Often the land is the only really valuable part of the cottage property. Moreover, the amount of land is sometimes much greater than ½ hectare. The Tax Court has considered quite a few appeals from taxpayers claiming the exemption for more than ½ hectare of land, and taxpayers have had some successes especially where it can be shown that local by-laws prohibit the subdivision of the land into a parcel smaller than the lot for which the exemption is being claimed.

Calculating the Exemption

The Act contains a formula for calculating the exemption. A taxpayer, in computing a capital gain in respect of the disposition of a principal residence, is entitled to deduct from the gain an amount given by the following formula:

A X (B ÷ C)

where

A is the taxpayer’s gain otherwise determined.

B is one plus the number of taxation years after 1971 during which the taxpayer (1) owned the property for which the property was the taxpayer’s principal residence and (2) during which the taxpayer was resident in Canada for the purposes of the Act.

C is the number of taxation years after 1971 during which the taxpayer owned the property.

As a result of item B above, only a person who was a resident of Canada while owning property can claim the exemption. That is, a non-resident can claim the exemption for a property only in respect of years during which he or she owned the property while a resident of Canada.

Roughly speaking, the gain on which tax will actually be payable is the proportion of the total gain otherwise calculated that the years of ownership during which the property cannot be designated is to the total years of ownership. The years when a gain accrues are irrelevant. For example, assume that Mr. X, a Canadian resident, owns a principal residence for ten years and that the value of the residence increases 30% only in the first two years of ownership. Mr. X designates the residence as his principal residence for the last two years that he owns the property. Nonetheless, Mr. X will be entitled to reduce the gain he would otherwise realize by 30% (ie gain otherwise realized X ((2 + 1) ÷ 10)). It does not matter that the gain accrued in years during which the property was not Mr. X’s principal residence.

Sudden spikes in property prices can lead taxpayers to second-guess choices they made about claiming the exemption. For example, assume that Mr. Y bought a cottage and a home in 1984 for $50,000 and $200,000 respectively. The home was worth more than the cottage, and its value increased more quickly, until he sold the home in 1994, when it was worth $300,000 and the cottage was worth only $60,000. At that time, Mr. Y needed to make a choice about whether to claim the exemption for his home or “save” it for the cottage. Given that the gain was significantly higher in the home than the cottage, he decided to claim the full exemption for the home, and he avoided a gain of $100,000 as a result. In 2004, however, he sold his cottage, when its value had risen to $500,000. Mr. Y’s gain in the cottage was $450,000. He can claim the exemption in respect of only 11/20 of the gain. That is, he must still pay tax in respect of a gain of $247,500. The gain he avoided on his home, however, by designating it as his principal residence was only $100,000. Perhaps Y would have been better off to claim the exemption only for this cottage.

It is not certain, however, that Mr. Y would have been better off to pay tax in 1994 in respect of the sale of his home so that he could claim the entire exemption for his cottage in 2004. One would need to take into account the time value of money, Mr. Y’s marginal rates in the years in question and the capital gain inclusion rates in those years to arrive at a better approximation of the choice Mr. Y should have made. Seen from the perspective of 1994, when Mr. Y was confronted with the choice, he would have had to consider the following issues (among others):

1. When would he sell the cottage?
2. What would the capital gains inclusion rate be at the time of the sale?
3. What would his marginal tax rate be at the time of the sale?
4. What discount rate should he use?

The answers to these questions would likely have been uncertain. Moreover, pity the poor adviser who must try to explain these factors to a client! In any case, the client should know that a choice must be made. We have encountered circumstances where it was clear that a client would have been better off not to claim the exemption on a home, but nobody advised the client about the choice to be made.

Other Planning

What if the exemption is not available to assist a client at the time of a sale or deemed sale (on death) of a cottage? Frankly, not much can be done after the fact. The key will be to put planning in place beforehand — preferably not long after a cottage is acquired — to eliminate, reduce or postpone the tax bill when the cottage is sold. For example, it might be possible to use a non-share corporation or a family trust to hold a cottage. A future article might examine these possibilities in more detail.

In considering these other forms of planning, however, advisers must remind their clients that the planning will have other, real-world consequences outside of the tax realm. Rose v. Rose, 81 O.R. (3d) 349, 2006 CanLII 20856 (ON S.C.) is a cautionary tale about a man who did some tax planning and lost a lot of money as a result.

Conclusion

Cottages can be expensive from a tax perspective. Cottage properties that have been in the family for many years can become unaffordable especially when they are deemed to be disposed of on death. The principal residence exemption can reduce or eliminate the taxes that must be paid in such circumstances, but the utility of the exemption can be impaired by the fact that a couple must choose between their home and the cottage in deciding where to use the exemption. Other planning might be available to reduce, defer or eliminate income taxes in respect of a cottage. An inter vivos trust or a non-share corporation could help, but they will be most useful if put into place sooner rather than later after a cottage is acquired. Advisers, however, must help clients to consider the other real-world consequences and risks of such planning.