Considering a Vacation Property?
Don’t let vacation dreams become your financial nightmare.
Fantasy
The dog days of summer spent fishing off the dock, the sun sinking slowly behind the distant shore, the call of the loon, or cross-country skiing and a warm fire at the end of a winter day. Whether these are fond memories of childhood or an imagined future, the desire to own a vacation property for personal use or even for investment purposes may blind you to the real cost of owning a second home.
Reality
Year-round vacation properties are costly. For example, getting a mortgage may be a challenge, especially if you do not have at least 20% of the property’s appraised value as a down payment. (Some banks offer financing for 95% of the property’s value, but default insurance − often referred to as mortgage insurance − is required on any amount over 80% of the appraised value and, in some cases, on any amount over 65%. Canada Mortgage and Housing Corporation stopped providing second-home default insurance effective May 30, 2014.)
Cash Flow Needed
Assume, as an example, a purchase price of $300,000, and that you have 20% as a down payment (i.e., $60,000). A mortgage amortized over 25 years with an interest rate of 4% (the projected interest rate of 4% is simplified for the purpose of example only; however, it is important to anticipate changes − including possible increases − over time) will result in payments of about $1,260 per month. This means mortgage payments alone will be approximately $15,120 per year. In addition to the capital outlay and mortgage payments, other costs should be recognized:
furnishings
municipal taxes, insurance, utilities and maintenance
tools and household items (e.g., lawn mower, snow blower, dishes, bedding, etc.)
monthly management fee (optional)
transportation costs back and forth to the property.
Rental Income
To offset the cost of ownership, you may consider renting out the property for part of the year. But before doing so, consider the following:
Income Tax Consequences
Any rental income you receive must be reported to the Canada Revenue Agency (CRA) and added to your other income. Naturally, expenses incurred to earn rental income are deductible. Expenses can include a reasonable apportioning of costs incurred for renting out versus personal use. Costs that can be considered for vacation property are not dissimilar to those for any other rental property. It would be wise to maintain records of the times the property is rented in order to provide a mathematical means (e.g., a percentage of the days or weeks of the year) of assigning costs to the rental or personal-use periods. Capital cost allowance on depreciable property can be deducted against property income only to the point where the profit is zero. You cannot create an operating loss or increase a loss with capital cost allowance. Because there are other tax issues when utilizing capital cost allowance that occur “down the road,” it is advisable to gain an understanding of tax consequences from your CPA to ensure the vacation property does not become an income tax nightmare.
Renting your vacation property to help with costs could trigger a “change in use” to the CRA.
Change in Use
Renting the property more than occasionally could trigger a “change in use” in the judgment of the CRA. Once a change in use is determined, the property is considered to have been disposed of at fair market value and a calculation of the gain or loss between the original cost and the “deemed disposition” price may trigger a capital gain on the difference. There are, however, other elections that can be made to defer the deemed disposition. Make sure to get the advice of a qualified tax advisor if you plan to rent the property for more than occasional use.
Multiple Residential Properties
There is nothing to prevent a taxpayer from owning more than one residential property; however, the Income Tax Act allows only one principal residence. Thus, if you already own your primary residence and subsequently purchase a vacation property, it will be necessary to consider the tax consequences of selling one of the properties in the future. In a nutshell, at the time the first residence is to be sold you must decide to either elect this property as your designated principal residence or defer the election until the sale of the second residence. When the designated principal residence is sold, any gain in value throughout the period of ownership is not considered to be a capital gain and is therefore not subject to capital gains tax. However, any gain on the sale of the property not elected as the principal residence will be regarded as a capital gain and taxed accordingly. Whichever property has the greater gain at the time of sale should probably be deemed your principal residence.
Something to Think About
Assume for a moment that two taxpayers decide to enter a common-law relationship or marry. Under CRA rules, if one person owns a traditional home and the other a vacation property and both properties are carried into the new relationship, tax laws dictate that only one property can be considered a principal residence. From the CRA’s point of view, it does not matter that as single persons each owned a principal residence that would not have been subject to capital gains tax if it had been sold before the parties entered into their new relationship.
A Final Perspective
The total cost of ownership of a vacation property over the 25-year amortization period can be substantial. To the original $300,000 price of the property, you have to add in the $140,000 (rounded for simplicity) interest cost to carry the $240,000 mortgage at 4% over 25 years. Add to that a conservatively estimated $5,000 per year for taxes, utilities, insurance and maintenance and you have an additional $125,000. This gives a total ownership cost of $565,000 ($300,000 + $140,000 + $125,000). Assume also that the property is sold after 25 years for $600,000. Because only half of any capital gain is taxed, you would be taxed on $150,000 in the year the property is sold. Assuming a 40% tax rate, the tax liability on the taxable portion of the capital gain will be $60,000. As a result, the actual cost of owning a $300,000 cottage for 25 years will be $625,000 ($565,000 + $60,000) or $25,000 per year.
Certainly the overall cost of (approximately) $625,000 can be reduced by renting the property but, as suggested above, exercise care to ensure the property does not become redefined by the CRA as an income- producing property with all its potential tax consequences.
Calculate the Best and the Worst
No one can accurately predict interest rates, tax rates or property values 25 years into the future. In the final analysis, purchasing a vacation property as a long-term investment should be tempered with a measured look at the real cost of holding the property and the return that may eventually be realized when the property is sold. Prudence would suggest running the best and worst case scenarios to determine whether such a long-term investment meshes with your current lifestyle and risk profile.
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