A Realtor friend tells me that a growing trend is for upwardly mobile suburbanites to acquire second homes in downtown urban areas, close to cultural attractions and amenities. Yet the demand for seasonal properties also remains strong, for those who crave a taste of the country.
No matter where your second home is located, be it an apartment in downtown Vancouver or Halifax, or a cottage in Ontario’s Muskoka region, or on a lake north of Saskatoon, that home away from home is not normally your principal residence, and the appreciation in value will one day be taxable. Why does it always come down to tax? Death and tax, those are certain.
Some people with two residences have been trying to cut their tax bill by declaring a different principal residence each year. Yes, the rules allow you to do this, and they’re spelled out in CanRev’s Interpretation Bulletin IT120. But here’s where it starts to get complicated.
Declaring a different residence each year or some years will result in a deemed change of use. It could be a partial change in use because you rent out part of it to a stranger or to family at fair market value rent. Alternatively, it could be a complete change in use if you decide to claim your other capital property as your principal residence in the year. You would have another change in use if you changed the property back to your principal residence again at any time.
This could be a way to crystallize the capital gain on the cottage or principal residence, but would you want to do this? You might find yourself paying tax without having the proceeds to pay the tax with, depending on the situation.
Of course, if there is a capital loss, you could utilize it against capital gains to reduce the total tax you pay in the year; excess losses could be applied to the previous three years or carried forward for future use. Every accountant and valuator in the country will either love or hate me for this.
When you decide to change the use of your principal residence, either to a rental or because some other property is where you have declared you live for that year, you trigger a "deemed disposition" of a "capital property." Sometimes you can elect to defer payment of the tax until the property is sold, but that is not always the case.
"Deemed proceeds of disposition" are equal to fair market value, so it is wise to employ the services of a certified evaluator of property to evaluate and provide you with a valuation as of the date of the change. Fair market value is usually the highest dollar value you could sell your property for in an open, unrestricted market between a willing buyer and a willing seller who are acting independently of each other. When you decide to change the use again, you would have a second or third deemed change in use, with a resultant deemed proceeds and capital gain or loss calculation. You should document the valuation each time.
If you are not sure about where you want to live, you might decide to rent out the upstairs and live downstairs, only to discover that you really don’t appreciate having renters stomping around overhead. Next time, you might choose to live upstairs while the renters live downstairs. Or family might move in downstairs for a year followed by a new tenant. Getting dizzy? Each time you change the use, you will have a deemed disposition on a partial change in use too.
Not only do you need to calculate the gain or loss every time this happens, you may have to split the calculation between the land and the building.
Land and buildings that are depreciable property are valued separately for tax purposes at acquisition and at disposition. There is a complex calculation of the value of the land and building compared with the proceeds in order to determine if a bump in the land value is required so as not to create a terminal loss on the building each time you have a partial or a complete change in use.
Any change in use, partial or complete, from a principal residence to a capital (read non rental) or rental property will trigger these calculations. Whether you pay the tax now or later, you will pay tax if there is a gain. Sometimes those calculations actually net you a loss, which can be carried forward indefinitely once you’ve offset any current-year gains. (Losses can be carried back for three years.)
If you borrow to invest in a cottage or apartment as a home away from home, the interest will not be deductible unless you are generating income from the property. When you choose to be a landlord, even for only part of the year, a portion of the interest, property taxes, condominium ("strata" in BC) fees, or other maintenance, repairs, and utilities may be deductible against the income generated from the rents. But be careful — this could put you offside for deferral of a gain on a change in use.
Keeping track of the number of days or months that the property is rented is important if your change in use is sporadic. This might be something to consider if you are purchasing an apartment for anticipated future demand (say, the 2010 winter Olympics in Whistler) or for those months you don’t use the apartment in the city because the roads just aren’t worth risking in the winter.
The potential to rent out the home away from home for big bucks on a short-term basis sounds really good until the reality of being a landlord sinks in. (Storing your own belongings in the interim, selecting and cleaning up after tenants, collecting rent, maintenance, and so on, can quickly become the focus of your life.) Suddenly it isn’t looking so profitable. Add to that all the tax calculations, and you might think twice. (I know about this first-hand from my own great adventure in the realm of bed and breakfast during Expo ’86 in Vancouver. I figure I broke even when I factored in the sweat equity and laundry soap, but it was fun, and I did meet some interesting people.)
Owning capital property
There are a number of ways to own capital property, each with its pros and cons.
Through a corporation. If the property is used for personal use with some corporate or other rental component, it is better not to have the corporation own the property. The corporation is required to charge or to cause a benefit to be added to your T4 for the opportunity cost of the investment. In other words, it may be that if the funds had been invested in the market rather than in property, the company would have earned considerably more. You may find yourself with a substantial taxable benefit — equal to the excess of the fair market value rent you might have paid to rent a similar propety — for the use of the company property under Section 15 of the Income Tax Act (under the shareholder benefits rules).
Through a family trust. Another method of ownership is to transfer the property into a trust. At that point there is a deemed disposition and a gain or loss calculation. Every 21 years, if the trust continues to own the property, there is another deemed disposition on which tax on any gain is payable by the trust. Family trust ownership removes the property from personal ownership. If the original owners die or any of the beneficiaries of the trust die, the property is still owned by the trust. You would take this course if you wanted the property to stay in the family and not trigger a capital gain at the date of death.
Remember, at date of death you are deemed to have disposed of all of your capital assets. With a trust, you in effect "dispose" of your assets before you die.
Annual reporting is required by the trust on a T3 Trust return. If the property is rented out, the trust is required to pay tax at the highest marginal tax rate on the income. The income could be allocated to the trust beneficiaries, so that they pay tax on it.
If the trust has not paid out the income to the beneficiaries, then only preferred beneficiaries could have income allocated to them — for example, a person who qualifies for the Disability Tax Credit would be a preferred beneficiary. All other beneficiaries must receive the cash in order to have the income allocated to them by the trust.
Sheila Fraser, my hero and our Auditor General, reported in November 2006 that trust allocations were not checked very sceclosely by CanRev. CanRev is now busy filling in the holes in the trust reporting. Expect more stringent follow-up on trust reporting in the near future.
Joint ownership. Owning a capital property either as tenants in common or in joint tenancy is a discussion you should have with a lawyer. Depending on which province or territory you live in, there are differing opinions about whether you are in a partnership or not if you own a capital property with other people.
Partnership tax calculations and reporting rules are a whole other kettle of fish. The complications when you die holding this type of property are interesting (some would say "challenging"), especially when proof of the percentage of ownership is not well documented or in dispute.
Not for faint-hearted
Owning capital property and designating or changing use of principal residences is not for the faint of heart. Please do not for one minute believe that this is all there is to it when it comes to the tax consequences. The calculations, the methods of ownership, and the pitfalls if you fall offside make it an area of tax best explored with a professional accountant and a lawyer conversant in property law, tax law, and your particular circumstances.
My recommendation is to seek professional help with structuring ownership and with tax return preparation whether you own dirt on a lake or up a mountain or a chunk of concrete in the heart of your favorite city.