The 2017 Royal LePage Canadian Recreational Housing Report showed healthy year-over-year price increases in many vacation property markets across Canada. The highest average price was $816,700 in Alberta, but even the national average was more than $400,000.
Over time, the price increases can be staggering. Waterfront cottages on the Bruce Peninsula in Ontario that sold for an average of $250,000 in 2005 cost almost $465,000 in 2017.1
If you own vacation property whose value has skyrocketed, you might feel like you won the lottery. Trouble is, that price increase is a capital gain, which is taxable. When you sell the property or leave it to your children or grandchildren, there could be a huge tax bill.
For example, assume that you inherited a cottage 35 years ago, when it was worth $40,000. Today, it’s valued at $600,000. That represents a capital gain of $560,000. At a 50% marginal tax rate, that translates into a tax liability of $140,000.
Reducing the tax bill
As vacation property values climb, so does the potential tax liability. Here are some strategies to help minimize or offset the tax bill.
Claim the principal residence exemption. Under the principal residence exemption, capital gains are exempt from tax, so if your vacation property has appreciated more than your home, you may want to designate it as your principal residence. In order to make the claim, you, your spouse or any of your children must have lived in the property at some time during the year.
There’s a bit of a catch, however. You can claim only one principal residence per family. So for years in which your vacation property is exempt, any increase in the value of your home will be exposed to tax on capital gains.
Let your kids have the property. Gifting or selling the vacation property to your children now triggers a taxable capital gain in the year of transfer, but tax on any future appreciation becomes your children’s responsibility.
The downside here, in addition to an immediate tax bill, is that you relinquish control of the property. You no longer have any say in how it is managed or who has access.
Establish a trust. Instead of giving the property to your children directly, you can transfer it into a trust and name your children as beneficiaries. The transfer triggers a taxable capital gain, but the trust owns the property, allowing you to establish rules over its use and care. Tax on future appreciation is deferred until the beneficiaries sell the property or pass away but must be paid every 21 years if the trust remains in existence.
Purchase life insurance. Life insurance can be a cost-effective way to cover capital gains tax and preserve your estate. Simply purchase life insurance on your life in an amount estimated to match the vacation property’s eventual tax liability. Your children are named as beneficiaries and they apply the tax-free proceeds to offset the tax liability associated with the property.
Talk to us if you own or expect to inherit vacation property. We’ll help you determine whether one of these strategies or another method suits your personal situation.
1 Royal LePage Recreational Property Report 2005 and 2017.