Author Segal LLP

Smart Planning Can Lead to Owning Your Own Lakeside Cottage

060917_Thinkstock_153499887_lores_kwThe Victoria Day long weekend recently kicked cottage season into gear and many taxpayers are thinking about whether to buy a summer cottage, sell one or give one to the kids.

Each of these choices has tax implications.

First, let’s say you’ve been renting the same cottage each summer for years and now the owner is settling some affairs and has asked if you’d like to buy it. You’ve spent many years there, your children have built up memories there and you plan to continue spending summers at the lake. You take the owner’s offer.

There are no tax implications for you that result from the purchase. There are issues, however, for the owner, which may apply to you later, as you’ll see below.

Canada Revenue Agency (CRA) will consider the cottage a personal-use property provided it’s used primarily by you or your relatives.

Adjusted Cost Base

However, you’ll want to start tracking the adjusted cost base (ACB) of the cottage. The higher that figure, the lower any taxable gain you’ll have to report once you dispose of the property either by selling it or transferring ownership through gifting or inheritance.

The adjusted cost base includes the original purchase price plus qualifying capital outlays such as:

  • Upgrades to the property (you’ll have to demonstrate that the original purchase price would have been higher if the repairs hadn’t been necessary),
  • Renovating to winterize a property or add new elements to the structure such as additional bedrooms or new bathrooms,
  • Building a new deck,
  • Installing windows or a roof that are better than the originals, and
  • Putting in a new well or pump.

General repairs don’t count as capital improvements and you can’t value any work you personally perform on the home.

The excess of the proceeds of disposition deemed or realized over the ACB (and any selling costs) is generally a capital gain for income tax purposes.

If you simply sell the property, you can designate it as your principal residence, take the exemption on any capital gain and sell it tax-free. A cottage can be designated as your principal residence for each year in which you, your spouse or common-law partner, and/or your children were residents in Canada and ordinarily lived in it for some time during the particular year.

To optimize the benefit of the exemption, taxpayers generally apply it to the property with the greatest accrued gain. Keep in mind, however, the property can’t be income-producing during the years it is designated as a principal residence.

In the past, when you disposed of your principal residence, you didn’t have to report the sale on your tax return if you were eligible for the full exemption. That has changed. Starting with the 2016 tax year, the CRA grants that exemption only if you report the sale and designation of principal residence on Schedule 3, Capital Gains of your income tax return. You’ll be required to report basic information such as a description of the property, the date you sold it and the proceeds of disposition.

The rules of the principal residence exemption are complex, so consult with your tax advisor.

Capital Losses

You generally can’t deduct a capital loss on your cottage when you calculate your income for the year. You also can’t use a loss to decrease capital gains on other personal-use property. When property depreciates through general use, the loss on its disposition is a personal expense.

If you’re primarily renting out the cottage, however, you may be able to claim a capital loss. But keep in mind that you may lose the personal-use exemption if you rent it out for most of the year. That exemption can come in handy to help shelter any gain from the disposition if the cottage appreciates in value.

If you rent it out only occasionally to help defray some costs of ownership, talk with your tax advisor about how to report income and expenses on your tax return.

Change of Use

This brings up the issue of the changing use of the property. On the day you begin to rent the place, CRA considers that you sold the cottage and, on that same day, reacquired it — with both transactions at the fair market value of the property on the day. Normally, the CRA won’t apply the change-in-use rule if you meet three conditions:

1) Your rental of the property is secondary to your use of it as the family vacation property,

2) You make no structural changes to earn income, and

3) You don’t claim depreciation (capital cost allowance) on the property.

If you don’t meet those three conditions, you’ll need to calculate and report a capital gains tax or loss on the difference between the fair market value and the property’s adjusted cost base (ACB). Under the new reporting requirements that started for the 2016 tax year, you’ll have to report the deemed sale on Schedule 3, Capital Gains or Loses, of your tax return for the year of the deemed sale.

Rental income is taxable, but you can claim some expenses to offset the income, including:

  • A reasonable portion of the operating expenses, and
  • Costs directly associated with renting the property (such as cleaning, advertising, commissions or fees paid to rental agents, and property management fees).

Estate Planning

Another choice to make is whether you want to pass the cottage on to your heirs. If that is your goal, first check with them to determine if they want the cottage. If they do want it, you need to decide who gets it, how they get it and how they’re going to pay for maintaining it. If you can’t claim the principal residence exemption on the vacation home, the children will need to pay a capital gains tax when the second parent dies.

They should be prepared for a shock. Although the capital gains tax is 50% of the gain, the hit could be significant if you’ve owned the cottage for years given the rise in property prices.

You could transfer the property before you die — or gift it — and pay the tax. To avoid other potential complications, for example an ex-spouse of one of the kids makes a claim on the property, you may consider creating a trust.

Consult with your tax advisor, who can help you sort through all the financial and estate-planning implications.

Need to Increase Your Retirement Cash Flow?

lores_mortgage_options_types_rates_lengths_terms_mbRetired people sometimes find themselves in a cash bind, but there might be a solution for homeowners in the form of a reverse mortgage. You’ve probably seen ads on television or in magazines about this type of mortgage and wondered if it could work for you. Reverse mortgages can be a useful tool for seniors who have built up equity in their home and are looking to supplement their cash flow in retirement but they are not for everyone.

What Is a Reverse Mortgage?

A reverse mortgage is a loan secured by a home, like any other mortgage. Unlike a regular mortgage, no re-payment of the loan is required until the home is sold, the last surviving spouse dies, or the owner moves out.

Additional Requirements:

  • You must be at least 62 years of age.
  • The home must be your principal residence.
  • Any existing mortgage must be paid off by the proceeds of the reverse mortgage.

Why Is It Called a “Reverse” Mortgage?

A regular mortgage balance decreases over time as payments are made, until finally it is paid off. In a reverse mortgage, the balance increases over time due to interest charges. This is the reverse of a regular mortgage.

How it works: Depending on your age, marital status, and the property, you can unlock as much as 40 per cent of the appraised value of your home. (See right-hand box for additional requirements.)

Let’s say you’ve paid off – or nearly paid off – a conventional mortgage and the home is valued at $300,000. You could wind up with a tax-free $120,000 cash advance. You can take the money in a lump sum or in instalments over the time you remain in the home.

Payments aren’t due until the home is sold or the surviving spouse dies, although you can opt to pay the mortgage earlier. The lender makes its money by recovering the principal and interest when the home is eventually sold.

On the face of it, these mortgages appear to be a good deal for several reasons:

  • The money received is not taxable.
  • The cash advance doesn’t affect government benefits programs such as Old Age Security and the Guaranteed Annual Supplement.
  • Payments are deferred as long as you remain in the house.
  • The mortgage will never exceed the fair market value when the house is eventually sold.
  • You can use the money any way you want (in fact, you can use the money to buy an annuity or purchase life insurance to pay off the reverse mortgage, which means you can still leave the home free of debt to your heirs).
  • You can still sell the house if that becomes necessary, although there may be an early repayment penalty.
  • If you choose to pay the mortgage interest annually, the payment may be tax deductible if the borrowed money is invested.

However, before deciding a reverse mortgage is the tool for you, there are some disadvantages to consider:

  • Interest rates are as much as two percentage points higher than on a conventional mortgage. For example, if conventional mortgage rates are five per cent, a reverse mortgage could cost you seven per cent. The rates are set annually and based on the rate for one-year Government of Canada bonds.
  • Interest continues to accumulate, so in theory the loan, plus interest, could eventually exceed the value of your home. If you sell the house, proceeds will be used to repay the debt and you would have nothing left.
  • Set-up, appraisal and legal fees can run from about $1,800 to as much as $2,300.
  • You cannot move to another home and keep the loan, which means you can’t rent out the place and still keep the reverse mortgage cash advance.

Proceed with Caution: If you think a reverse mortgage might work for you, consult with your accountant first. Generally, a reverse mortgage is a last resort alternative for homeowners.

Inside Job: Countering Cash Skimming

thmb_sales_cash_drawer_register_retail_money_teller_change_amLike Taking Milk from a Baby

Cash skimming is one of the most common and easiest types of occupational fraud, regardless of an organization’s size. Fortunately, there are relatively uncomplicated ways to fight it.

Look for These Red Flags
Regardless who skims money, the effect on your enterprise remains the same: Revenue is lower than it should be while the costs of producing it remain the same.
There are warning signs that indicate the possibility of fraud at your organization. Here is a checklist of tell-tale signs. They don’t necessarily indicate fraud, but the more red flags the greater the likelihood skimming is occurring at your business:
1. Declining or flat revenue.
2. Increasing cost of sales.
3. Increasing or excessive inventory shrinkage.
4. Narrowing ratio of cash sales to credit card sales.
5. Shrinking ratio of cash sales to total sales.
6. Increasing ratio of gross sales to net sales.
7. Discrepancies between customer receipt and company receipt.
8. Customer complaints and inquiries.
9. Forged, missing or altered refund documents.

The term comes from the fact that money is taken off the top, the way cream is skimmed from milk. The reasons cash skimming can be so easy — and tempting — is that the money is often stolen before it’s ever recorded. That means there’s no need to alter accounting records or convert stolen goods into cash. There are many variations on the skimming theme, and two of the most common are:

1. Unrecorded sales: A salesperson sells goods or services to a customer and collects the payment, but doesn’t ring up the transaction. This is sometimes accomplished by opening the business on weekends or after hours and pocketing all or most of the cash receipts.

Here’s another example that doesn’t involves sales: An apartment house manager collects rents in cash for an apartment that is shown as being vacant.

2. Understated sales: An employee records a sale for less than the actual price and pockets the difference. In another version, the employee records a discount that the customer never receives and pockets the amount of the discount.

But skimming can also target refunds and accounts receivable. Those variations, however, require some alterations to books and records to avoid detection. For example, in receivables skimming, the thefts are often those that are simply unrecorded on the books. When funds are diverted from accounts receivable, the amount owed can be reduced on the books by write-off schemes.

Since any employee who comes in contact with cash can skim money, the usual suspects are salespeople, cashiers, mail clerks, and bookkeepers. But keep in mind that senior executives can easily override controls and skim cash. When senior management is involved the losses are usually much larger.

The key to preventing this type of fraud is to set up controls. How you go about doing that depends on the number of employees and the complexity of your enterprise’s accounting system.

Even a very small business can have effective internal controls that may consist simply of the owner carefully paying attention to a few cheques and keeping tight controls over employee access to cash and other assets. In any case, employees who handle cash should be bonded.

At the top of the list of effective ways to battle skimming is to segregate employees’ responsibilities. This means being sure that:

  • The person receiving payments and opening mail doesn’t also record incoming payments. Cheques that are received should be stamped “for deposit only”.
  • Cash receipts should be sequentially numbered, and all receipts should be accounted for.
  • A list of money, cheques and other receipts received in the mail should be prepared by someone other than the bookkeeper or individuals who record payments.
  • Bank deposits should be made by someone who does not receive cash and cheques. The same applies to custody of deposits.
  • Individuals with signing authority on bank accounts should not be responsible for bookkeeping or reconciling the bank accounts.
  • Cash refunds and discounts should require approval.
  • Cashiers should not have access to bookkeeping records, bank statements, incoming mail, or customer statements.

These controls can be put into effect with as few as three people. If you are the owner and the bookkeeper, only two people are needed to put these controls into effect.

Talk to a professional about other types of fraud and how to protect your company’s bottom line from less-than-honest employees.

Like Taking Milk from a Baby

Reap Tax Benefits from an Earn-Out Agreement

lores_canada_money_dollars_coins_calculator_pen_glasses_mbOrdinarily, any income from your business or property is fully taxable but when you sell your business you benefit from a capital gains tax, where only half of the proceeds from the sale is taxable income.

But let’s say you sell your business under an earn-out agreement where the buyer pays a partial amount up front and the remainder is derived from and based on meeting certain financial goals. The precise amount of your proceeds cannot be determined at the time of sale and, in fact, may not be known for several years.

That type of earn-out agreement depends on the use of — or production from — the company’s property, and ordinarily the money generated would be taxed as business income, not as a capital gain.

Canada Revenue Agency (CRA), however, recognizes that bind and allows you to use the cost recovery method of reporting the gains or losses if you meet the following five conditions:

  • You and the buyer deal at arm’s length.
  • The gain or loss is clearly of a capital nature.
  • It is reasonable to assume that the earn-out feature relates to underlying goodwill and that the two parties cannot reasonably be expected to agree on that value at the time of the sale.
  • The duration of the agreement does not exceed five years.
  • You, as the seller, file a copy of the sale agreement with your income tax return for the year of the sale, send a letter requesting the application of the cost recovery method to the sale, and agree to follow the cost recovery procedures.

Keep in mind, however, that if the deal amounts to an installment plan it is not considered an earn-out agreement for purposes of using the cost recovery method.Under the cost recovery method, you reduce the adjusted cost base (ACB) of your company’s shares when you are able to determine the amounts that will be paid. Amounts exceeding the ACB are considered a capital gain and the ACB becomes nil. All amounts that can then be calculated with certainty are treated as capital gains.

So let’s say your company’s stock’s ACB is $120,000 and you sell them all in an earn-out agreement. The sale price for the shares is $100,000 up front plus additional payments based on an earn-out formula over the next four years. The first $30,000 payment is due the year following the year of the sale. Here’s how the cost recovery works:

Year of the sale: You report no capital gain or loss, but the $100,000 reduces the ACB of the shares to $20,000 ($120,000 minus $100,000).

Year after the sale: The $30,000 payment due exceeds the $20,000 ACB, so you recognize a capital gain of $10,000. Half of that is included in your income as a taxable capital gain. You adjust the ACB of the shares to nil.

Following three years: The remaining payments under the earn-out formula are treated as capital gains, half of which are taxed.

The CRA recognizes a capital loss only when the maximum payable to you is less than the ACB of the shares. In that instance, the loss can be reported at the time of the sale. If, over time, it becomes clear that the actual total paid will be less than the initial maximum amount, a further capital loss can be claimed.

If there is no maximum amount set out in the agreement, a capital loss can be reported once it can be established that the total of the amounts to be paid will not exceed the ACB of the shares.

Let the Wedding Bells Chime – After You Sign a Prenup

050417_Thinkstock_450149657_lores_ABFirst you say “Yes,” then you say “I do.” But between those two momentous events, some couples are choosing a third way to seal the deal: signing a prenuptial agreement.

Planning a wedding may leave little time for anything else, but consider this: A prenuptial agreement (also called a domestic contract or a marriage contract) may be as critical a negotiation as the price of food at the reception. And think about this: 43.1% of marriages end in divorce before a couple reaches their 50th anniversary, according to Statistics Canada’s 2011 snapshot on the topic of divorce.

Even couples who live together but aren’t married should consider having a cohabitation agreement. If you do marry, you can convert it to a prenup. Some couples arrange postnuptial agreements, which accomplish the same thing but are signed after the marriage — in some cases, years later.

When drafting and signing these agreements, both sides should have independent legal counsel.

Talking about finances, including how marriage or a common-law partnership will affect your taxes may seem pessimistic because it presumes the possibility of a divorce. But look at it as a form of insurance. People don’t buy a home assuming it’ll fall apart, but they buy homeowners insurance. Safe drivers buy auto insurance and healthy people have health and life insurance. It just makes sense. Prenups protect both spouses.

One way to ease the potential discomfort of broaching the subject is to say that your accountant or legal counsel insists you have a written agreement as part of your financial and estate plan.

So what exactly is a prenup? It’s simply a legal agreement that outlines how you’ll divide your assets in the event of a divorce. And it isn’t just for wealthy people. It works for everyone.

Blending Your Finances

Financial disagreements are one of the leading causes of marital problems. So, it’s important to consult with your tax advisor, banker and legal counsel before you tie the knot to get a handle on your financial, tax and estate planning strategies as a joint household. Here’s a checklist of important steps to consider:

1. Candidly discuss joint finances. For example, how much debt is each of you bringing to the marriage? What about savings? How is your credit rating? The older you are, the more (good and bad) financial baggage you may have.

2. Decide on joint or separate bank accounts — or both. Your banker can walk you through what will be needed to combine checking, savings and money market accounts.

Even if you decide to maintain separate accounts, it’s often helpful to have at least one joint account to pay for shared expenses, such as the costs of a mortgage or rent, household expenses and childcare. This account can be used for your combined needs, and it allows you both to keep track of how you’re spending money.

A joint account can also help avoid trouble and delays in case of death. If a spouse or common-law partner dies and there are separate accounts, the survivor could be unable to access the account until the estate goes through probate. That could take months.

3. Update deeds, wills and power of attorney documents. An attorney can discuss the full array of estate planning tools, such as various trusts, which might be relevant once you’re married.

4. Plan financial goals as a couple. Create an annual budget, as well as a contingency plan in case a spouse gets laid off or becomes disabled. Make sure you have several months’ income saved as an emergency cash reserve. Designate who’ll be responsible for paying the bills and reconciling the checkbook. Also look beyond your current financial situation. For example, discuss what you envision your retirement will look like, and whether current retirement account contributions are sufficient to achieve your long-term goals.

5. Review beneficiaries and the amount of life insurance policies. As your marriage progresses and if you have children, remember to update the beneficiaries of policies as well as retirement accounts. These assets will be distributed to your named beneficiaries, regardless of the terms of your estate planning documents. Coordinate designations with your estate plans. Review how much life insurance you hold. Do you need more to ensure that any children are treated fairly and equally?

6. Check property titles. Jointly owned property automatically passes to the co-owner.

Tax Benefits

Once you’ve determined how to split assets in the event you separate or divorce, turn your attention to taxes. Among the tax benefits are:

  • Spousal credits. You may claim this credit if, at any time in the year you support your spouse or common-law partner, you weren’t living separately because of a breakdown in the relationship, and his or her net income is less than $11,474 in 2017. However, if you claim the family caregiver amount for your spouse or partner, his or her net income must be less than $13,595. The amount is reduced on a dollar- for-dollar basis by the dependent’s net income. This credit could save you as much as $1,745 in federal taxes.
  • Transferred credits. Taxpayers whose income is too low to benefit from certain tax credits, may be able to transfer some to their spouses, including the age, pension, caregiver, disability and tuition (up to $5,000) credits.
  • Pooled medical expenses. You may claim medical expenses for your spouse or common-law partner when you file your tax return. You may get a bigger tax credit if the partner with the lower income claims all of the medical expenses for the couple. This is because the tax credit for medical expenses is based on a percentage of your income.
  • Pooled charitable contributions. You’re entitled to a 15% credit on the first $200 of charitable donations and a 29% credit for every dollar over $200. By pooling your donations together, you can reach the $200 threshold faster. As a first-time donor, you and your spouse or common-law partner may share the First-Time Donor’s Super Credit in a specific tax year. However, the total amount of donations that may be claimed for this credit can’t exceed $1,000. When it can’t be agreed on the amount of the credit that each of you will claim, the CRA may apportion the credit.
  • Split pensions. Up to half of eligible pension income can be transferred to your spouse or common-law partner. You’ll both be able to claim the pension credit and tax savings can be significant. Note: You and your spouse or partner don’t have to split the same percentage of pension income every year.

Tax-free rollovers. Designate your spouse as beneficiary of your Registered Retirement Savings Plan and Tax-Free Savings Accounts and then tax-free rollovers will be available after one spouse dies. In addition, when you die, you’ll be deemed to have sold all your assets. That can generate a capital gains tax. If you leave the assets to your spouse, taxes will be deferred until your spouse dies, or sells the assets.

Get Independent Professional Advice

Make certain you discuss all of these issues independently with your advisors before you commit to a life together.