If anything defines the good life in Manitoba, it's cottage country.
Maybe not all of us are lucky enough to own a patch of paradise, but a good number of Manitobans do indeed own a cabin -- an asset that for many is priceless.
Still, as a cabin owner, you can't ignore the cottage's cash value. Even if the chance of selling is slim, the Canada Revenue Agency will get its piece of the action one way or another.
"There's no way to avoid taxes," says Aurele Courcelles, director of tax and estate planning at Investors Group in Winnipeg.
The taxes in question are those applicable to capital gains on the growth in value of the cabin between when you took ownership and when it's sold or passed on to someone who's not your spouse.
"But there are ways to lower the tax," he says.
In fact, owners have plenty of options. Yet figuring out which one of these options makes the most financial sense can be a tall order for Joe and Jane Public.
So, just for the sake of argument, let's pretend Joe and Jane own a $500,000 cabin -- a family meeting place since they bought the land and built the cabin in 1967.
And for the purposes of news that readers can use, Joe and Jane's cabin will illustrate the potential tax nuances of passing on the family's jewel by the lakeside.
The taxman cometh...
Joe and Jane bought the land and built the cottage themselves for $30,000 45 years ago. Having held on to the cabin until now, they don't have to pay any taxes on the cabin's growth in value until they sell it, gift it to their children or leave it to them in the will.
"Upon the death of one spouse, if any assets are left to the surviving spouse, it all rolls over to that spouse tax-free," says Courcelles.
That includes real estate.
Before the cottage could pass to their children, for example, the estate would have to pay taxes on the accrued gain -- which one would assume is $470,000 based on the price they paid in 1967, subtracted from the price the cabin would sell for today.
The advantageous part about capital-gains taxes is only half of a capital gain is taxable. So while a large portion of the cabin's gain will most likely be taxed at the highest rate in Manitoba, 46.4 per cent, only half would be taxable. Still, that's possibly a $109,040 tax bill.
But that's highly unlikely, because the gain in value is reduced by additions to its original cost to arrive at what's called the adjusted cost base. This calculation includes not only the price paid for the cabin, but expenses for renovations that improve the property beyond its original state. In this example, Joe and Jane bought the cabin for $30,000. And let's say they did $20,000 more in renovations over the years, such as building a deck and adding running water.
One thing to keep in mind: Repairs are not improvements. So a new roof likely won't count in the calculation, but new steps might if instead of replacing the original wooden steps, they built concrete steps.
In our example, if the adjusted cost base is increased to $50,000, the total capital gain is only $450,000, making the tax bill that much smaller.
But the fun doesn't stop there. It gets more complicated.
Exemptions to the rule...
Most cabin owners also own a home. Another upside of Canadian tax law is that when we sell our home, we don't get taxed on the capital gain. We can pocket the profit, tax-free. That's the principal residence exemption.
But owners with two or more properties also have the opportunity to choose which property they want to be their principal residence.
"As long as you use the cottage regularly -- on weekends or a few times a year -- that's sufficient to be a principal residence," Courcelles says.
In a perfect world, it's just a matter of deciding which property has the largest capital gain and then selecting it as the principal residence while choosing to pay taxes on the other property when it's sold or passed on to family.
In reality, nothing is quite so cut and dried.
Most people sell their home and buy another, using the principal residence exemption, without even knowing it exists. Still, they can choose later on to use the principal residence exemption on their cabin for the years they did not claim it against the home they sold.
In our example, Joe and Jane might have bought a new home after they sold their old home in 2004 for $250,000, profiting $75,000.
At the time, the cabin was worth $350,000. Today, if they decided to sell the cabin, they could declare it as their principal residence for the years after 2004. But they might still have to pay taxes on the gain prior to the date they sold their first house -- not to mention making the gain on their new home taxable.
At first glance, you might think taxable gain on the cabin is $300,000. That's subtracting the adjusted cost base of $50,000 from the gain between 1967 and 2004.
But it's likely to be much less. Canadian tax laws on capital gains have changed several times since 1967. In fact, the family cabin would be eligible for three tax exemptions that would dramatically reduce the tax bill.
The '94 election
This isn't a reference to an election in which you vote. Instead, it's a tax form -- an election to declare as much as $100,000 of capital gains on a property without paying taxes.
"Under the law today, you can declare $750,000 of capital gains, tax-free, on the sale of qualifying small business corporation shares or farm property," Courcelles says.
But up until 1994, Canadians had a $100,000-capital gains exemption on any asset with a capital gain. That changed in 1994, but the government gave Canadians, including cabin owners, a chance to file an election with CRA to use the exemption of $100,000 if they hadn't already used it up in years prior. Two exemptions could be made if a property was jointly owned. (By the way: If you didn't use the exemption in '94, you're out of luck.)
In our example, Joe and Jane both had the foresight to file the election. In 1994, their cabin was worth $320,000 and they could use the full exemption.
The total taxable gain at that time would have been $70,000 -- based on the $30,000 price of the cabin, $20,000 in upgrades and two $100,000 exemptions -- one for Joe and one for Jane -- subtracted from the 1994 market value.
So the adjusted cost base on the cabin would be $250,000, and the capital gain would be $250,000 if Joe and Jane sold it today.
But hold on. Two more exemptions prior to 1994 must be taken into account.
More than just free love...
The 1960s also were free of taxes on capital gains. Capital gains tax laws didn't exist until the 1970s. But once in place, any gains made before 1972 were grandfathered, Courcelles says.
In our example, the cottage appreciated in value from 1967 to 1971 to $80,000. That $50,000 growth from the purchase date would be tax exempt. So, the valuation date in 1971 would be $80,000. To keep things simple, no improvements took place until the mid-'80s, so the adjusted cost base in 1994 would have been the sum of the 1971 valuation date of $80,000, the $20,000 in upgrades and the two $100,000 exemptions. That's $300,000, leaving only $20,000 in gains taxable in 1994. But it doesn't stop there.
2 homes better than one...
After 1971, capital gains applied to cottages that weren't a principal residence. But the rules allowed a married couple to have two principal residences.
This rule changed in 1982. Afterward, a married or common-law couple could own only one principal residence, Courcelles says.
In the case of Joe and Jane, they owned both a home and a cabin up to that point. In 1982, the cabin was worth $120,000. With some proper tax planning to maximize their principal residence exemption claims, going forward that could be the adjusted cost base.
The price is right...
So what are the taxes payable on Joe and Jane's cabin?
Because the cabin could be exempted until 1982, the adjusted cost base to that point would have been $120,000. Add on the upgrades and the cost base is $150,000 in 1994. With the $100,000 exemptions claimed by both Joe and Jane as much as possible (they would have $30,000 between them left over for capital gains on other assets prior to '94), the cost base would be $320,000. And that just so happens to be the cabin's value at that time.
Going forward, Joe's and Jane's adjusted cost base would have been $320,000. When they sold their home in 2004, the cabin was worth $350,000. Because they used the principal residence exemption on the sale of their home, they would have to pay taxes on the gain from 1994 until 2004 on the cabin if they chose afterward to make the cabin their principal residence until today.
Call an expert...
Now Joe and Jane have a decision to make about how best to pass on the cabin to their kids. But even before they get to that stage, Courcelles says they should find out if their kids even want it. If they don't, it might make sense to sell it. They know the gain on the cabin is about $180,000 today, so the tax bill could be as high as $41,760 if they sold it (much less than the $109,040 we assumed at the outset). Or they could make it their principal residence instead and pay taxes eventually on the sale of their home. Yet they'd still have to pay taxes on the cabin's gain from 1994 to 2004 -- only $30,000 -- because they used the principal residence exemption on their home's sale in 2004.
Certainly, they should consider seeking professional advice.
Joe and Jane might not know all the tax rules and miss their chance to reduce their tax bill, Courcelles says.
"And it could be a very expensive mistake."