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Vacation Property Strategies

Much has been written in the financial press regarding the various tax rules which apply to cottage properties. For the reasons outlined below, many people are looking at planning alternatives regarding their vacation property with a certain sense of urgency.

Prior to 1982, a husband and wife could each own a principal residence, the disposition of which was exempt from capital gains tax. Thus it was common for one spouse to own the house and the other spouse to own the cottage. In Allan MacEachen's infamous budget of 1981, however, the rules were changed so that a married couple can, since the end of 1981, own only one principal resident.

The February 1992 federal budget introduced rules to phase out the capital gains exemption for real estate which is not used in an active business. These rules preserve the exemption for capital gains accrued on such properties prior to March 1992 on the basis of a formula which essentially prorates any capital gains over the pre-budget and post-budget periods. For many property owners, the effect of this formula is that entitlement to the capital gains exemption, which is a maximum of $100,000 lifetime per individual, is eroding with each passing month.

For example, let's assume the purchase price on Jan. 12, 1982 was $220,000 and the sale price on July 1993 is $340,000. The amount of gain eligible for the capital gains exemption is the number of months the property was owned before March 1992 divided by the total number of months the property was owned multiplied by the capital gain, or: 122/138 x $120,000= $106,087

In this example, since the pre-budget portion of the capital gain is greater than the maximum capital gains exemption of $100,000, the taxpayer would be able to claim his or her maximum available exemption, although the balance of the capital gain would be taxed in the usual way.

Now let's assume all the same facts as in first example, but with one change - now the sale takes place in July 1994. The new equation would look like this: 122/150 x $120,000= $97,600

In this second example, with one extra year for the phase in rules to work, the maximum available reduced to $97,600. Therefore, even if the taxpayer has used one of his or her exemptions, only this lesser amount will be available.

Therefore, with many vacation properties having lost their status as principal residence, and with the capital gains exemption being phased out in respect of these properties, many property owners are looking for ways to take advantage of the capital gains exemption regarding these properties before the new rules have had a chance to do much of their dirty work. Now, lets discuss a number of income tax and other considerations involved in this issue.