Home Cottage Law: Tax Deduction Opportunities

Owning a cottage or a vacation property comes with several tax implications. While it is possible to claim a cottage as your principal residence and have the proceeds be tax-free, it is uncommon, as most people's homes are worth more than their secondary property. However, there are a number of expenses that can be claimed to reduce the capital gain on a cottage, such as capital expenses, which increase the cost base and reduce capital gains tax. Additionally, if you rent out your cottage, there are tax-deductible expenses to consider, such as management and administration fees, mortgage interest, utilities, and advertising costs. Understanding the tax implications of owning and renting out a cottage is crucial for effective financial planning.

Can a home cottage law be tax-deductible?

Claiming a cottage as a principal residence

If you own a cottage, you may be able to claim it as your principal residence, even if you don't live in it all year round. This is because, in Canada, every family is allowed to claim one property as their principal residence for any given year, and this residence is exempt from capital gains tax. As long as you reside in it for a part of the year, even a seasonal cottage can be deemed your principal residence.

However, there are a few things to keep in mind. Firstly, if you are married or in a common-law relationship, you and your spouse can only designate one place as your principal residence. Secondly, claiming a cottage as your principal residence may trigger capital gains tax on your family home for every year it is not deemed your principal residence. Therefore, it is important to consider which property has the highest value gain per year of ownership and designate that as your principal residence. Additionally, if your cottage is used primarily as a rental property, you may lose the option of claiming it as your principal residence.

When claiming a cottage as your principal residence, it is important to keep complete and accurate records, including all original purchase documentation and any invoices, receipts, or proof of payment related to capital improvements. While you cannot include the cost of your own labour for a DIY improvement, you can include the cost of materials.

If you are considering claiming a cottage as your principal residence, it is a good idea to speak with an accountant or financial advisor to ensure you are making the best decision for your specific circumstances.

Capital expenses

There are several examples of capital expenses that cottage owners can consider. Windows, flooring, and a stove are generally considered capital expenses, as they provide a lasting benefit and add to the value of the property. These expenses would be added to the cost of the property for capital gains tax purposes. It is worth noting that the CRA specifically mentions that expenses for wooden steps are considered current expenses and are not classified as capital expenses.

When selling a cottage, the calculation of your cost base for tax purposes includes the original purchase price, closing costs on acquisition, and capital expenses incurred over the years. Understanding the concept of a capital gain is crucial. A capital gain occurs when there is an increase in the value of an asset, including stocks, mutual funds, and real estate, and it is "realized" when the asset is sold. Conversely, a capital loss is realized when an asset is sold for a lower price than its purchase price.

If you are renting out your cottage, there are additional capital expenses to consider. Management and administration fees, mortgage interest, utilities, and advertising expenses can all be deducted from your rental income. Furthermore, if you incur legal, accounting, or other professional fees related to the rental, these may also be deductible against rental revenues. However, it is important to note that you must have a profit motive and consistently charge fair rental value to claim these expenses.

Lastly, if you have made improvements to your cottage, you can capitalize on the cost of materials used but not the imputed cost of your own labour. This can be an important consideration for do-it-yourself (DIY) cottagers looking to improve the tax efficiency of their recreational home. Overall, understanding and properly documenting capital expenses can help cottage owners optimize their tax deductions and minimize their capital gains tax liability.

Rental losses

If you own a cottage or vacation property, you may be able to claim certain tax deductions. For example, capital expenses, such as replacing a shingle roof with a metal one, can reduce your capital gains tax liability. Repairs, on the other hand, are generally not tax-deductible unless the property is used for rental or business purposes, in which case they can be deducted against the income earned.

In terms of rental losses, it is important to understand the difference between passive and non-passive income. Rental losses are typically classified as "passive losses" by the IRS, which means they can only be used to offset passive income. Passive income refers to income earned from rental real estate or other passive activities, such as investments or savings accounts. Therefore, rental losses cannot be deducted from income earned through employment or other non-passive sources.

However, there are exceptions to this rule. One exception is the $25,000 rental real estate loss allowance provided by the IRS. This allowance is available to taxpayers who actively participate in the rental activity and own at least 10% of the value of the property. To actively participate, an individual must be involved in making meaningful management decisions regarding the rental property. This allowance begins to phase out when the taxpayer's modified adjusted gross income (MAGI) exceeds $100,000 and is completely phased out when MAGI exceeds $150,000.

Another exception to the passive loss rules is for real estate professionals. Unlike the $25,000 allowance, this is a complete exemption, allowing qualifying landlords to deduct any amount of losses from their non-passive income. To qualify, an individual must spend more than half of their total working hours during the year in one or more real property businesses.

It is important to maintain good records of your rental income and expenses. These records will help you prepare your tax returns and support the items reported on them. In the case of an audit, you must be able to provide evidence to substantiate your expenses and income.

Tax implications on death

While there is no inheritance tax in Canada, there are some tax implications to be aware of when someone passes away. Here are some key points to consider:

• Final Tax Return: A final tax return, also known as a terminal tax return, must be filed by the executor or liquidator of the estate. This includes all income earned by the deceased up to the date of death, as well as any capital gains or losses. The estate is treated as a sale by the Canada Revenue Agency (CRA), and taxes are deducted from it. Any resulting capital gains are 50% taxable and added to the deceased's income, taxed at the applicable personal income tax rates.
• Deemed Disposition: All capital property owned by the deceased is considered disposed of and sold for fair market value immediately before death. This includes non-registered assets such as personal belongings, cars, investments, and business assets. If these assets have increased in value since their acquisition, the estate will owe taxes on the capital gains in the year of death.
• Principal Residence Exemption: If the deceased owned a principal residence, some or all of the capital gains on that property may be exempt from tax. However, this exemption only applies until the date of death. The land on which the home is located can be part of the principal residence, usually limited to half a hectare, but this limit can be exceeded if more land was necessary for the residence to function as such.
• Transfer to Spouse or Common-Law Partner: If property or assets are transferred to a surviving spouse or common-law partner who is a Canadian resident, it may not result in a capital gain or loss in the final return. This transfer must occur within 36 months of the date of death. The capital gain or loss is postponed until the surviving spouse sells the property.
• Probate Tax: The executor of the estate may be required to file for probate with the provincial court, paying a probate tax based on the total value of the assets in the will. However, probate is not required for all types of wills, and the tax can be reduced through various strategies.
• Registered Assets: Registered assets, such as Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs), must be deregistered and included in the deceased's final tax return. However, there are exceptions if these assets are left to a surviving spouse, common-law spouse, or, in some cases, a surviving child or grandchild. In these cases, the assets can be transferred tax-free.
• Inheritance: Money received from an inheritance is not considered taxable income by the CRA, so beneficiaries do not need to pay taxes on it. However, the estate may have paid taxes on the income before it was released to the beneficiaries. If the beneficiary invests the inheritance and earns income from that investment, they will be taxed on that income.

It is important to consult with a tax professional or financial advisor to understand the specific tax implications for your situation, as there may be additional considerations or exemptions not covered here.

Tax-deductible expenses

If you own a cottage, you may be able to claim it as your principal residence and have the proceeds be tax-free. However, this is uncommon as most people's homes are worth more than a secondary or vacation property. Additionally, a taxpayer can only claim one principal residence per tax year.

When it comes to tax-deductible expenses, there are several things to consider. Firstly, if you are renting out your cottage, there must be a profit motive, and you must consistently charge fair rental value to claim expenses. Allowable expenses are typically deducted in the calendar year they are incurred and must be matched to the revenue earned in the same period.

• Management and administration fees: If you pay a third party or a service like Airbnb to manage the cottage rental, those fees are deductible.
• Mortgage interest: This is deductible, as is the interest incurred when taking out new loans to improve the property.
• Utilities: If you provide utilities as part of the rent, they are deductible.
• Motor vehicle expenses: While travelling expenses are generally considered personal living expenses, you can deduct the cost of transporting tools and materials to the property if you personally travel to make repairs.
• Home office and office supplies: These expenses are deductible as long as they are incurred to earn rental income and prorated for any personal use. Property taxes and utilities for your home office can also be deducted, but be mindful of claiming capital cost allowance (CCA) if you intend to use the cottage as a tax-exempt personal residence.
• Advertising: Amounts paid to advertise the cottage's availability in local papers, on social media, and rental websites are deductible.
• Insurance: The additional costs of insuring a rental property are deductible against rental revenues.
• Landscaping costs: These may be deducted in the year they are paid.
• Legal, accounting, and other professional fees: Legal fees incurred to prepare leases or collect rent are deductible against rental income. Legal fees paid to acquire the property or during its sale will form part of the cost of the property, reducing any future capital gain. Accounting fees for preparing statements, keeping records, and preparing tax returns are also deductible.
• Capital expenses: These are expenses that increase your cost base and reduce your capital gains tax on the property. For example, replacing an old shingle roof with a metal one or making improvements to windows and flooring.

Frequently asked questions