Two months ago, a woman in her mid-sixties and her granddaughter were visiting Ontario from Alabama, vacationing in Muskoka.
They liked the region so much that they offered to buy the cottage of some friends of mine - James and Kate. Now James and Kate love their cottage, but when the woman offered 50 per cent more than the fair value of the place, they agreed to sell.
Hmm. Sounds fishy to me: A woman from Alabama with money to burn.
The first thing that came to mind was the news out of Alabama earlier this year of abuses in the financial aid program at one of the state colleges, whereby significant athletic scholarships were awarded to relatives of employees who did not even play sports - including one employee's 67-year-old grandmother, who received scholarships in three sports. I suggested to James and Kate that they ask the woman whether she had ever received a football scholarship. But I digress.
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The fact is, James and Kate are selling their cottage this year, and for a significant profit.
They're concerned about the tax bill.
Can anything be done?
PRINCIPAL RESIDENCE
The principal residence exemption is a valuable tax provision because it allows taxpayers to sell a principal residence (which can include a cottage) free of tax. This could solve the tax problem James and Kate are facing. The problem they face is that each family unit (which includes you, your spouse or common-law partner, and unmarried kids under 18) is entitled to designate just one property as their principal residence (PR) per year. James and Kate have owned two properties since 1974 - their Oakville, Ont., home, and the Muskoka cottage - both of which were acquired that year.
Now things were different prior to 1982, when each individual was entitled to his or her own exemption, regardless of any exemption claimed by a family member. As a result, it was possible for a couple to shelter the tax on two different PRs for years prior to 1982.
To claim the principal residence exemption on a property sale, you have to designate, on a year-by-year basis, one of the properties as your PR. You make the designation in the year you sell one of your properties by filing Form T2091 with your tax return for the year of the sale.
PRINCIPAL STRATEGY
Back to James and Kate. Both properties have been jointly owned by them since they were acquired in 1974. The properties have appreciated in value by about the same amount. Don't forget, James is entitled to designate one property as his PR for each year prior to 1982. In addition, Kate is able to designate one property as her PR for each year prior to 1982. Finally, James and Kate together can designate one property for the years after 1981.
Absent proper tax advice, here's what James and Kate might do: James could shelter his half of the cottage from tax by designating that property as his PR for the years prior to 1982. Kate would also have to designate the cottage as her PR for the years prior to 1982 in order to shelter her half of the cottage from tax. For years after 1981, only one exemption is available and they could designate the cottage for those years as well. The result? No tax on the sale of the cottage to the grandmother from Alabama. But the sale of the Oakville home would be taxable eventually.
Want a better idea? James and Kate could separate the ownership of the two properties today by changing title so that James owns one property and Kate owns the other. The taxman will now consider each spouse to have owned each property individually (not jointly) from the day they were originally acquired.
Let's assume that James now owns the cottage. He could shelter the cottage from tax by designating it as his PR for the years prior to 1982. For years after 1981, only one exemption is available and the couple would designate the cottage for those years.
The result is twofold: There is no tax to pay on the sale of the cottage this year since it has been designated as a PR for every year it was owned. Further, Kate has not yet designated a property as her PR for the years prior to 1982. She could designate the Oakville home for those years. The result? We've now sheltered part of the eventual gain on the Oakville home as well.
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