Second Property? How to plan for your taxes
Owning a second property has its luxuries. Whether it’s used for winter family ski trips or summer vacations on the lake, you may find yourself with extra tax obligations associated with the property.
Regardless of where you own property in Canada, it is subject to property taxes associated with its location. Unfortunately, there is not much you can do to eliminate this bill.
If you choose to rent out your second property for parts of the year for extra income, you are required to pay taxes on the income you’ve received from the rental. However, apart from using the rental income, you can use expenses associated with the property to offset the income tax if properly structured.
The often most expensive tax obligation for a second property is the capital gains associated with the increase in value of your property. If your property was purchased 20 or 30 years ago, it might have increased in value significantly over the last few decades.
The current capital gains inclusion rate is 50%. Meaning, half of the growth in the value of your property will be taxed at your highest marginal tax rate. This can happen at either the time of sale, the time of transfer, or at the time of death. If you own your property jointly with your spouse, the at death tax bill will occur at the second death.
Another challenge may occur if your family does not want to sell the property and intends to keep it for future generations. Regardless, the taxes on gains will still need to be paid in the event of a property transfer after your death.
How can you reduce your capital gains tax obligation?
There are some strategies you can do to plan for the inevitable capital gains tax bill:
1. Principal Residence Exemption (PRE)
To shelter the gain on your second property, you may be able to use your Principal Residence Exemption (PRE) if you meet the CRA rules for usage of the property. Often, the PRE is associated with your primary residence (PR). However, if your vacation property has increased in value more than your primary residence, you may choose to use the exemption against the gain on the income property (either at sale or time of death). If you designate the vacation property as your PR for all of the years that you own it, you will be able to use 100% of your exemption. If you designate it as your PR for a portion of the years you have owned it, the following formula will apply:
Exemption Amount = Capital Gain X (Number of years designated as PRE + 1) / (# of years owned)
*The +1 accounts for the possibility of having two PREs in a year that you purchase and sell a property
For the years your second property was designated as the primary residence, your other property will not be eligible for exemption and will be subject to tax on any related gain. Effectively, you are shifting the tax bill to the property with the lesser gain.
If your vacation property is a cherished place where family and friends come together, you may be interested in keeping it in the family. Consider setting aside other assets or insurance to fund the capital gains tax bill once you pass on. Insurance can be beneficial as the policy gains are tax-free and payout at the time of death, the same time the tax bill is triggered. Your family or beneficiaries can use the insurance payout to cover this expense.
With all the planning strategies available, understanding what you want to do and why you want to do it will give the best initial clues toward the right approach. There are tax, legal and financial considerations associated with planning for a vacation property, and it is vital to have advisors in those areas to make sure plans are structured and appropriately documented. Additionally, there are emotional factors and relationship factors involved that can often thwart even the most expensive and bulletproof of plans. Having an advisor who helps lead your family conversations and understands your objectives will be the best person to mediate the team and ensure that your goals drive the plan.