The 3 Hidden Financial Traps of Cottage Ownership

Vacation homes can create difficult tax considerations when transferring to children or grandchildren. (AP Photo/Nick Ut)

If you already have a cottage in the family, there may be looming ownership, tax, and estate-planning problems if you’re thinking of selling or transferring to a new generation. Here are the three top issues to be aware of whether you already own a vacation property or you’re contemplating buying one.

1. Your tax partner

All cottage owners have a silent partner—the Canada Revenue Agency. That’s because of something called the “principal residence exemption.”

A principal residence is a dwelling that someone ordinarily inhabits at some point during the year. That can include a vacation property. Effectively, it means you don’t pay capital gains tax when you sell the property you designate as your principal residence.

Our tax laws state that a couple can have only one principal residence. For most of us, that’s our home in town.

When you sell your recreational property, then, you'll pay capital gains tax on an appreciation in the value of the property from when you purchased it.

So along with all those ongoing maintenance costs, property taxes, and other expenses associated with ownership of a vacation property, you'll be paying a good chunk of any gain in value (less improvements, so keep those receipts) to the federal government—something north of 20 percent at least.

2. The principal residence conundrum

In fact, there’s nothing to stop you from designating your vacation property as your principal residence and claiming the exemption on it. But you'd do this only if it makes financial sense—for example, if the average annual gain on the vacation property exceeds the gain on your home.

3. All in the family

Many people have sentimental reasons for keeping a vacation property in the family by transferring it to children or grandchildren. Taxes will have to be paid in the event of a transfer.

Sometimes, the tax bill can be reduced if parents or grandparents took advantage of something called “Valuation Day,” January 1, 1972, which involved assigning an acceptable value to the property as of that date.

Essentially, any capital gain before that date will not be subject to capital gains tax. The V-day value (less improvements made since then) for these types of properties is considered to be the adjusted cost base for determining capital gains tax.

Transferring the title to the recreational property to your kids or grandkids, or holding title in joint tenancy, cannot be used to circumvent the tax bill. The CRA will still treat any such transfer as a deemed sale, and demand you pay capital gains tax.

Rather than going through all these machinations, many cottage owners simply opt to purchase life insurance that will cover the tax on the deemed sale of the property on the death of the owner. Here again, you’re going to need some knowledgeable financial help, because it’s easy to buy too much insurance.

If you’re thinking about buying that slice of paradise by the lake, or thinking about selling or transferring ownership, your best bet is to consult a Certified Financial Planner with insurance expertise who can help you navigate the many legal and tax pitfalls that accompany cottage ownership.

Courtesy Fundata Canada Inc. © 2014. Robyn Thompson, CFP, CIM, FCSI, is president of Castlemark Wealth Management. This article has been edited from its original version. This article is not intended as personalized advice.