So, it seems that the big rise in real estate prices, particularly in Toronto and Vancouver, has made its way into cottage country.
In Ontario, for example, the median price of waterfront property in the Muskoka, Haliburton and Orillia regions has increased by more than 30 per cent over the past year, according to the Lakelands Association of Realtors. And realtors in the Kawarthas, Whistler, Tofino, the Okanagan, Columbia Valley, Quebec’s Eastern Townships and Nova Scotia have all reported high interest and brisk sales.
I’ve seen a related theme emerging. Whether it’s a cottage, cabin, camp or chalet, more Canadians are looking to defray the cost of ownership by earning some rental income, or trying to deduct some of the costs related to their vacation homes. My friend, Matt, is no different. He shared his story with me this week, and it raised a couple of issues. Let me explain.
Matt and his wife bought a cottage last year. The cottage is on an island in Muskoka and it takes a short boat ride to get from the mainland to their place. It was an expensive purchase, so Matt has done a couple of things.
First, they’ll be renting the cottage for the month of August this summer. Matt figures they’ll earn $1,700 a week, or about $6,800 by renting it out. Matt hired a contractor last fall to add three small bedrooms to the cottage for renters to use. This way, they can lock the other bedrooms that his family uses when they’re at the cottage.
Matt is self-employed and has several customers within an hour’s drive of his cottage, which works well for him because he can stay at the cottage and still earn a living while he’s there. Not a bad arrangement. He’s planning to deduct part of the cost of his boat because he uses it to get to the mainland for work, and periodically takes customers for rides. He figures he’ll cut his boating costs by about 25 per cent by deducting a portion of his costs.
I didn’t want to rain on Matt’s parade, but there were a few things he didn’t understand. First, Matt has jeopardized his ability to claim his principal residence exemption (PRE) to shelter any gain on the sale of the cottage later. It’s not the rental activity itself that’s the problem. You can rent part of your cottage and still be entitled to the PRE, but only if you meet three conditions: 1) your use of the cottage as a rental is ancillary to your use of the place as a personal vacation property, 2) you don’t make any structural changes to the place to earn income and 3) you don’t claim depreciation (capital cost allowance) on the property. Matt did make structural changes to his cottage, so he’s offside here.
So, the portion of the cottage that is used for earning rental income will not be eligible for the PRE. This could result in a tax bill later if the property is sold for a profit. But there’s more. There are “change-in-use” rules that will apply to Matt. If these rules apply, Matt will be deemed to have sold, on the day he begins renting the place, that portion of his cottage he is now using to earn rental income. He’ll also be deemed to have reacquired that portion of the property at the current value on that same day. Normally, the taxman won’t apply this change-in-use rule if the three conditions above are met. Matt is out of luck here. Now, he can likely use his PRE to shelter any gain on the change in use if he wants – but he should talk to a tax pro about it. As an aside, Matt will have to report the deemed sale on Schedule 3 of his tax return for 2017 given the new reporting requirements around dispositions of principal residences.
Next, although Matt is hoping to deduct a portion of his boat costs, the taxman has written about this before and won’t allow it. If an expense is considered personal in nature, it won’t be deductible against income from business or property. Although Matt does need to get from his cottage to the mainland to work, the cost of travelling from home to work is considered a personal expense. What about using the boat to entertain customers? Our tax law explicitly denies expenses associated with a “yacht,” which has been interpreted to mean a vessel used as a pleasure craft – including Matt’s 22-foot bowrider.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.