Imagine that you just inherited a beautiful lakefront cottage that your parents spent their whole life making beautiful for you their heirs to enjoy. The cottage is located on a scenic lake with crystal clear water with a few other cottages surrounding it. That was what happened to a client of mine just recently. She and her two brothers were just getting over the passing of their parents when they received a strange letter from Canada Revenue Agency (CRA), demanding capital gains taxes on the 'sale' of the cottage. Outraged and several profanities later, they arrived at my office for an explanation. Quite simply the taxing authority, (CRA) deemed the property to have been sold when title to the property changes.

Under the taxing authority's rules, if this were a principal residence then there would be no capital gains taxes. What is capital gains? Capital gains is simply the difference between the purchase price and the sale price of a secondary property or security. That difference is then taxed at 50% which is the taxable capital gains payable to the taxing authorities. Let's take my example of my client, Hillary Clinton and her two brothers Stephen Harper and Jim Flaherty. Their parents Mark Carney and Angela Merkal bought the scenic cottage in 1965 at a cost of say $25,000 and have renovated it over the years at a cost of say $10,000.

Cottage Original Purchase Price Estimated Market Value by taxing authority
year 1965 $25,000 2010 $500,000
renovations $10,000 N/A
equals $35,000 $500,000

The calculation of taxable capital gains is the original purchase price plus any renovations and other costs to acquire the property including legal fees, real estate commissions, etc. This is known as the adjusted cost base. In this instance the capital gains calculation is as follows:

$500,000 estimated market value year 2010
Less $ 35,000 adjusted cost base ($25,000 + 10,000)
$465,000 difference
x 50%
$232,500 taxable capital gains

In this instance the $232,500 is payable to the taxing authorities from the heirs Hillary Clinton, Stephen Harper and Jim Flaherty or $77,500 between the 3 heirs. If neither heir has the $232,500 then the cottage is put up for sale with the proceeds going to the taxing authorities and the heirs getting what is leftover after the sale.

The solution says, Mathew Jazenko, of Newmarket, Ontario, Canada based MRJ Financial Solutions, is to do one of two things. The first one is to get an insurance policy for the estimated value of the property and divide the premiums amongst the 3 heirs. When that inevitable day comes when you do inherit a second home or cottage, the insurance policy can be cashed in to pay the taxable capital gains.
The second solution is to convey or transfer title to the property to your heirs now. The benefit, the clock stops ticking as far as taxable capital gains go. The tax hit will be significantly lower now then later. When you do inherit the second home or cottage there will be no more taxable capital gains.

What happens when a spouse passes on, is there capital gains as well? In this case the spouse can choose an estimated market value. Let's take the previous example of the family cottage.

Cottage Original Purchase Price Estimated Market Value by the taxing authorities
year 1965 $25,000 2010 $500,000
renovations $10,000 N/A
equals $35,000

The spouse can choose any market value equal to or greater than $35,000 upto and including $500,000. The spouse in this case will choose $35,000 which makes the taxable capital gains zero. Remember this is just a tax deferral until the surviving spouse passes on and the beneficiaries take over.

Cottage Original Purchase Price
year 1965 $25,000
renovations, closing costs
and real estate commissions $10,000
equals $35,000
market value by the spouse $35,000
Taxable Capital Gains $---0----

What happens if I change my principal residence to the cottage? Then there will only be capital gains until the date you designate the cottage as your principle residence. Then sell your 1st house which is a principal residence, then designate the 2nd as your new principle residence. One other thing, the taxing authority says there can be only 1 principle residence at a time.

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