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.