Taking it Easy at Your Own Cottage Starts with Smart Planning
July 15th, 2016
The living seems so easy on the lake, at the beach or in the mountains.
If you’ve been renting a vacation retreat each year, you may think it’s finally time to dive in and buy one of your own. It can be the right choice, but be sure you go in with your eyes wide open.
Cottages can be pricey, not just because of the cost of purchasing a place but also because of ongoing maintenance, unexpected repairs and perhaps renovations. Don’t forget that what you spend on your cottage can have a significant effect on taxes when you sell it.
Before you sign the mortgage or withdraw from your savings, ask yourself if owning a cottage makes financial sense for you. Do you want to tie up a chunk of your savings in real estate?
Once you’ve mulled over these issues, you’re ready to start.
Choosing a Property. To ensure your cottage both fulfills your getaway dreams and is a financially smart choice, you need to find the right property in the right location for the right price. Two major possibilities will dictate what you buy and where:
1. Using the place as a retreat and a place to retire. A cottage for the family needs sleeping, cooking, dining and congregation areas adequate for family and guests. A potential place to retire should also have easy access to shopping, gas stations, hospitals and entertainment. If you’re planning to retire there, the place obviously needs to be winterized.
2. Earning extra money by renting out the house. A cottage can be easier to rent out when it’s located in a high-demand, and more expensive, area such as on a lake or near a ski resort. In general, the more isolated and quiet the location, and the further away from the water or other attractions, the lower the rent you can ask.
You also need to consider all of the costs involved. In addition to the down payment, any monthly mortgage payment and interest, you’ll incur costs such as:
- Property taxes, insurance
- Utilities, propane refills
- Condo, marina fees
- Maintenance, repairs
- Travel, gasoline
- Garbage, trash removal
Finally, if you need financing, that also should factor into the type of property you choose. Cottages often fall into one of two categories when it comes to getting a mortgage:
1. All-year winterized properties. These have features similar to residential homes such as insulation, running water all year, central heating and sometimes basements. These are good candidates for mortgages.
2. Rustic properties. These may have wood stoves or fireplaces and sit on blocks or piers. These may be more difficult to finance and may require heftier down payments to avoid mortgage insurance. The worst case scenario: You may have to tap into your savings.
Once you’ve sorted out these issues, it’s time to turn to tax planning. That’ll involve keeping track of the following:
Capital improvements. At some point, you’ll inevitably give up the cottage, either by transferring ownership (succession, gifting and inheritance) or selling it. Document any capital expenditures you make over time so you’ll be able to calculate an accurate adjusted cost base (ACB). The higher your ACB, the lower any taxable capital gain you’ll have to report.
Your adjusted ACB is the sum of the initial cost of the property plus qualifying capital outlays such as:
- Making changes to upgrade a property (you’ll have to demonstrate that the original purchase price would have been higher if the repairs hadn’t been necessary),
- Renovating to winterize a property or add new elements to the structure such as additional bedrooms or new bathrooms,
- Building a new deck,
- Installing new windows or a roof that are better than the originals, and
- Putting in a new well or pump.
General repairs don’t count as capital improvements and you can’t value any work you personally perform on the home.
The excess of the proceeds of disposition deemed or realized over the ACB (and any selling costs) is generally a capital gain for income tax purposes.
As you can see, keeping accurate documentation of outlays is critical, particularly if Canada Revenue Agency (CRA) wants documents to support the ACB.
Capital losses. You generally can’t deduct a capital loss on your cottage when you calculate your income for the year. You also can’t use a loss to decrease capital gains on other personal-use property. When property depreciates through general use, the loss on its disposition is a personal expense.
If you’re primarily renting out the cottage, however, you may be able to claim a capital loss. But keep in mind that you may lose the personal-use exemption if you rent it out for most of the year. That exemption can come in handy to help shelter any gain from the disposition if the cottage appreciates in value.
If you rent it out only occasionally to help defray some costs of ownership, talk with your tax adviser about how to report income and expenses on your tax return.
Changing use of property. Before turning your personal-use property into an income-producer by renting it out, discuss the tax consequences with your accountant. Rental income will be taxable, but you can claim some expenses to offset the income, including:
- A reasonable portion of the operating expenses, and
- Costs directly associated with renting the property (such as cleaning, advertising, commissions or fees paid to rental agents, and property management fees).
Estate Planning and Other Financial Implications
There are many other tax implications related to owning a vacation property, including estate planning issues. A cottage is often viewed as common property within generations. If you hope to leave the cottage to your heirs, you’ll need to determine whether you plan to pass it on with a will, a sale or a trust. If you’ve inherited a cottage, there are other tax and financial issues to consider.
Consult with your adviser, who can help you sort through all the tax, financial and estate-planning implications.