Tax tips for Buying and Selling a Cottage with Rental-income Opportunity
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Purchasing a cottage to rent out?
The plan to buy a cottage as a rental-income opportunity can be exciting, but before you sign on the dotted line, you’ll want to learn all you can about the new tax implications.
The huge rise in real estate prices, from detached homes to townhouses for sale in Toronto, has now entered cottage country. The Lakelands Association of Realtors will tell you that the median price of waterfront property in Ontario, such as the Muskoka, Haliburton and Orillia regions, has increased by more than 30 per cent over the past year.
One source has observed that more Canadians are seeking to defray or reduce cottage ownership costs by renting it out. Now, if you were able to swing the financing on a vacation property to rent out as recently as 2015, realtors had hailed the idea. You could potentially have earned $6,000 a season, or you might even have added a couple of renters’ bedrooms to the cottage and locked up other bedrooms for your personal use.
But if you’re buying a cottage in 2017, the rental landscape has altered, and, if you’re not careful about your renting habits, you might inadvertently be jeopardizing your ability to claim your principal residence exemption (PRE) to shelter any gain on the sale of the cottage down the road.
Rental activity is not precisely the problem. You’re allowed to rent part of your cottage and still be entitled to Principal Residence Exemption (PRE), BUT only if you meet these three conditions:
- Your use of the cottage as a rental is additional to your use of the property as a personal vacation property.
- You don’t make any structural changes to the cottage to earn income.
- You don’t claim depreciation (Capital Cost Allowance) on the property.
So, the portion of the cottage that is used for earning rental income will not be eligible for the PRE. This scenario could result in a tax bill later if the property is sold for a profit. In addition, because of the “change-in-use” rules (and you happened to add on rooms for guests), you’ll be deemed to have sold − on the day you begin renting the place − that portion of the cottage you are now using to earn rental income. You’ll also be deemed to have reacquired that portion of the property at the current value on that same day.
Normally, the tax laws won’t apply this change-in-use rule if those three golden conditions stated above have been met. Sources further note that you can likely use the PRE to shelter any gain on the change-in-use if you wish – but you are strongly advised to speak with a tax professional about all the implications.
In defraying other costs, such as allowing your renters to use a boat or other equipment, the tax law explicitly prohibits these kinds of expenses.
Selling the cottage?
Sources note that foreign speculators might initially have been the target of a new rule from Ottawa that has since been imposed to clamp down on the tax-free capital gains exemption on the sale of a homeowner’s principal residence, but house flippers and cottage owners are now involved in the fray.
The new rule says you must now report the sale of a principal residence on your tax return.
In the not-so-distant past, homeowners were obliged to report sales of secondary residences (such as cottages) that were subject to capital gains tax, while the sale of a principal residence was not mandatory to report.
This practice, however, had made it difficult for the Canada Revenue Agency (CRA) to track the frequency with which people were turning over their primary residences, especially house-flippers, and the crackdown has now created a complicated question about the principal residence exemption for cottage owners or people with secondary properties for personal use.
You can only claim the principal residence on one property but, historically, vacation properties have often been ignored in reporting. Sources note that legally you always had to disclose any sale of property, but CRA’s administrative policy was that you didn’t have to report a gain, if it was your principal residence.
Gains on a cottage or secondary property are considered taxable at the 50 per cent capital gains rate, unless you deem it as your principal residence, which, in turn, would leave you with a tax liability on your principal residence. The consequence is that if you sell a secondary property and report nothing on your return, the CRA deems that you’ve sold your principal residence and have used up the exemption. The further consequence is that you could face a major tax bill on your primary home that probably will have increased considerably in value.
Experts say that no real designation of principal residence is made until you sell. The minute you sell, you make the choice of whether to report it or not. If you don’t, however, the CRA deems you’ve made a principal residence exemption – and this means that when you sell the other property that you hold concurrently, you cannot use the exemption on that second residence.
While these laws haven’t exactly changed, the new catch is that if you sell your cottage first and don’t report the sale or capital gain, the CRA can now go back and reassess you indefinitely. As one industry authority explains: If you do nothing, which previously meant you were automatically claiming the exemption, the CRA can now say you’ve squandered that exemption and they can potentially fine you. Your best option at this point is to take the opportunity to refile your returns, saying you made a mistake.
When to claim or not to claim cottage losses?
If your cottage is like most vacation homes, it will be considered a “personal use property” under Canada’s tax laws, meaning that any loss on the sale of the property cannot be claimed. Similarly, if your cottage for personal use is destroyed, say, by fire or flood, the loss cannot be claimed.
On the other hand, if your cottage is primarily a rental property, you might be able to claim a capital loss in cases of disaster. But the recommendation is not to be too eager to rent out the premises most of the time, as this could jeopardize use of the PRE if the property appreciates in value − and you want to shelter the gain from tax.
Furthermore, if you’re renting the cottage part-time to offset ownership costs, you’d be wise to avoid reporting rental expenses in excess of your rental income, year after year. Those losses will only serve to raise eyebrows on your tax return and will probably be denied.
If you are curious about buying a cottage and renting it out as an income property, you can learn about the how to fund your mortgage, create a renovation budget or simply add to your savings account here.
Zoocasa is a real estate brokerage based in Toronto.