TAX TIPS FOR COTTAGES:

If a client wants to keep her cottage in the family, she should consider claiming the principal residence exemption when she transfers or sells the property to family members. This way, she’ll be able to pass the property tax-free. This applies whether the cottage is transferred, sold or even deemed sold upon death.

If she doesn’t use the exemption, she could face significant capital gains tax if the property appreciated in value, says Jamie Golombek, managing director of Tax and Estate Planning with CIBC Wealth Advisory Services.

For a cottage to be considered a principal residence, he adds, “it doesn’t have to be the place you principally live. It just has to be a place you live in ordinarily at some point during the year. So you could say your vacation property is your principal residence for tax purposes, even if you only spend a few months there.”

Still, many people who own cottages also own houses in cities. That means they have to decide whether to use the tax exemption on the eventual sale of the cottage and house.

Before your client claims the exemption on the sale of her cottage, she also needs to consider a number of factors. These include “the gain [or loss] on each property, the potential for a future increase or even decrease in the value of the unsold propert[ies], and how long [she’s] going to hold” each.

Golombek illustrates how a client can use the exemption: say she has two properties she bought in 2000. One of them she’ll sell in 2014 and the other she’ll sell in 2018. Both of them have gains, so she’ll have to decide whether to claim the principal residence exemption this year.

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He adds, “If you don’t report the [first property’s] gain, you’re deemed to have reported the exemption and you pay no tax. Then, when you sell your second property in 2018, you’ll effectively have had 14 years of dual ownership (2000 to 2014). So when you sell the second property, it would have 14 years of gains and four tax-free years.”

Clients can also use life insurance to cover the cost of property-related taxes upon death. “There’s a deemed disposition at fair market value and that can give rise to capital gains tax, even if you don’t sell the property,” says Golombek. “Permanent life insurance can be a very inexpensive way of ensuring that the tax liability gets paid with tax-free death benefit proceeds.”

In fact, this option can be cheaper and less complicated than other strategies, such as using a trust to own properties.

However, clients who have vacation homes in the U.S. must seek advice from a cross-border tax and estate-planning expert, he says, since U.S. and Canadian estate rules differ.