When a cottage property has increased in value, it often brings unwanted income tax and estate planning issues. I wrote about some of these issues a year ago April, in a three part series for the Canadian Capitalist titled Transferring the Family Cottage - There is no Panacea. In Part 1, I discuss the historical nature of the income tax rules, while in Part 2 I discuss the income tax implications of transferring or gifting a cottage and finally in Part 3 I discuss alternative income tax planning opportunities that may mitigate or defer income tax upon the transfer of a family cottage.
Today, I want to discuss the fact that the CRA seems to be looking at cottage sales as audit targets and in particular, they are reviewing additions to the original adjusted cost base (“ACB”) of the cottage.
Income Tax IssuesBefore I charge ahead with this post, I think a quick income tax primer is in order. Prior to 1982, a taxpayer and their spouse could each designate their own principal residence (“PR”) and each could claim their own principal residence exemption (“PRE”). Therefore, where a family owned a cottage and a family home, each spouse could potentially claim their own PRE, one on the cottage and one on the family home, and accordingly the sale of both properties would be tax-free.
Alas, the taxman felt this treatment was too generous and changed the Income Tax Act. Beginning in 1982 a family unit (a family unit of the taxpayer includes the taxpayers spouse or common-law partner and unmarried children that are 18 years old or younger) could only designate one principal residence between them for each tax year after 1981.
As if the above is not complex enough, anyone selling a cottage must also consider the following ACB adjustments:
1. If your cottage was purchased prior to 1972, you will need to know the fair market value (“FMV”) on December 31, 1971; the FMV of your cottage on this date became your cost base when the CRA brought in capital gains taxation.
2. In 1994 the CRA eliminated the $100,000 capital gains exemption; however, they allowed taxpayers to elect to bump the ACB of properties such as real estate to their FMV to a maximum of $100,000 (subject to some restrictions not worth discussing here). Many Canadians took advantage of this election and increased the ACB of their cottages.
3. Many people have inherited cottages. When someone passes away, they are deemed to dispose of their capital property at the FMV on the date of their death (unless the property is transferred to their spouse). The person inheriting the property assumes the deceased's FMV on their death, as their ACB.
The Principal Residence Exemption
As noted above, if you owned a cottage prior to 1982, you can make a PRE claim for those years on your cottage. Where the per year gain on your cottage is in excess of the per year gain on your home, you may want to consider whether for years after 1982, it makes sense to allocate the PRE to your cottage instead of your home, if you have not already used the PRE on prior home or cottage sales. In these cases, I would suggest professional advice due to the complexity of the rules. In completing the PR Designation tax form (T2091), there are cases where you may need the ACB and FMV at December 31, 1981, but I will ignore this issue for purposes of this discussion.
Putting together the pieces of the ACB Puzzle
So how do all these rules come together in determining your ACB? First, if you owned your cottage prior to 1972, you will need to determine the FMV at December 31, 1971 as that is your opening ACB. If you purchased the cottage after 1971, but before 1994, your ACB will be your purchase cost plus legal and land transfer costs. Next, you will have to determine whether you increased your ACB by electing to bump your ACB in 1994.
If you inherited the property, you will need to find out the FMV of the cottage on the date of the death of the person you inherited the property from. If the property was inherited before 1994, you will have to determine whether you increased your ACB by electing in 1994.
Finally, most people have made various capital improvements to their cottages over the years. For income tax purposes, these improvements are added to the ACB you have determined above. Examples of capital improvements would be the addition of a deck, a dock, a new roof or new windows that were better than the original roof or windows, new well or pump. General repairs are not capital improvements and you cannot value your own work if you are the handyman type. I would argue however, that the cost of materials for a capital improvement would qualify if you do the work yourself.
Unfortunately, many people do not keep track of these improvements nor do they keep their receipts (in addition, I suspect one or two cottage owners may have done the occasional cash deal with various contractors for which there will not be a supporting invoice), which brings us to the CRA, who appear to be auditing the sale of cottages more intently.
I think it was six pages back I said something about a quick income tax primer before I discussed the CRA audit issue :(
The Audit Issue
Anyways, on to the audit issue (or more properly called an information request). Some accountants think the CRA is going directly to cottage municipalities to determine cottages that have been sold and then tracking the owners to ensure they have reflected the disposition for income tax purposes. Others think the CRA is just following up reported dispositions of cottages on personal income tax returns. In either event, we have seen a couple information requests/audits recently.
So once the CRA decides to review your cottage sale, what are they looking at and what information are they requesting?
Amongst other things they are asking you to support the adjusted cost base of the property, by providing the following:
a. your copy of the original purchase agreement stating the purchase price;
b. the statement of adjustments where the purchase of the property involved the services of a lawyer;
c. if the property was either inherited or purchased in a non-arms length transaction, indicate the FMV of the property on the date of acquisition and supply documentation to support your figure. If the property was inherited, indicate the date of acquisition;
d. a schedule of all capital additions to the property. The schedule must indicate the nature of the addition or improvement (i.e. new roof) as well as the cost.
A and B above just provide the CRA the original ACB. Item C is interesting in that where there was a family sale or inheritance, the CRA is asking for validation of the sale price, but surely it is also cross-checking to see if the family member reported the sale of the cottage and in the case of a deceased person, to ensure the terminal income tax return of the deceased reported the value of the cottage at death.
Item D is where the CRA is zeroing in on; the capital additions, which as I noted above, are often not tracked and source documents are often not maintained.
The CRA is also asking for support of the proceeds of disposition, requesting such items as a copy of the accepted offer to purchase, the statement of adjustments and the full name of the purchaser in addition to their relationship, if any, to you (i.e. relative or otherwise).
They are also asking if while owned by you, was the property your principal residence for any period of time. This relates to the discussion above on whether the gain was larger on your cottage than your house and thus you designated your cottage. The CRA will then most likely confirm you did not sell any other residence during that time period.
Another request is that if you elected to report a capital gain on the property in 1994, they want you to supply a copy of the form T664, Election to Report a Capital Gain on Property Held at the end of February 22, 1994, that was filed with your 1994 income tax return. This is interesting since many people have not kept their older tax returns and I don’t think the CRA keeps its returns that far back. I am not sure what the CRA is doing in cases where taxpayers have destroyed their elections.
In conclusion, if you have sold a cottage in the last couple years, make sure you have all your documentation in place should you receive an information request, and if you currently own a cottage, use this road map to ensure you have updated your cottage ACB and have a file for any documentation needed to support that ACB.
The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.