Cottage ownership is a goal for many Canadian families. It means summer fun, family gatherings, childhood memories, family legacy, and an investment. But, unfortunately, it can also mean tax pitfalls. The following is a handful of the common tax pitfalls cottage owners should consider.

Principal Residence

The principal residence exemption is one of the most generous tax breaks in the Canadian tax system. It allows a family to be completely exempt from capital gain taxation when the family sells a property it has used as a principal residence. And the family doesn’t need to live in a property every day of the year for the property to be considered its principal residence. Therefore, a family can actually consider a cottage its principal residence in many situations.

The bad news is that one family can designate only one property as its principal residence for a particular year. However, the rules on this restriction are anything but straightforward. Through careful planning, it’s often, though not always, possible to partially or fully designate a cottage as a principal residence while, at the same time, the city home is fully designated as a principal residence for capital gain exemption purposes. This allows a family to be exempt, fully or to some extent, from the restriction of designating only one property as a principal residence.

Deemed Disposition

For many Canadian families, a cottage is part of the legacy of a family and should be passed down through the generations. To many parents, gifting a cottage to a child is a non-monetary transaction in which the Canada Revenue Agency should not be involved. But this is certainly not the complete truth. When gifting a cottage to a related person such as a child, parents can deem the transaction a disposition for income tax purposes and, as a result, would be taxed on the resulting capital gain. Of course, the parents can, in some situations, rely on principal residence capital gain exemption to mitigate the negative tax consequences.

Unfortunately, this isn’t the end of the unpleasant tax consequences. If the cottage earns rental income, the rental income would be taxed as the income of the parents rather than the income of the child. If parents plan to shift income to their child (who is presumably in a lower tax bracket) by gifting the cottage to him or her, the income attribution rules will defeat the entire plan.

More Than Rental Income

Sometimes owners may decide to rent out the cottage for a few years to generate rental income. Perhaps the family is now residing in another country or doesn’t have time to enjoy the cottage for a few years. When a personal-use cottage is rented out, there’s a change in use. The change in use could result in a deemed disposition, and the owner of the cottage could be taxed on the resulting capital gains—unless the change in use is properly dealt with beforehand for tax purposes. This is an area most taxpayers (and, in fact, many professional accountants, except those specializing in tax) are not aware of. The rationale is simple. Taxpayers don’t generally expect that they need to pay tax— unless there’s an actual sale and they’ve received an amount or amounts.

It’s not always easy to dedicate those precious summer hours to considering the tax consequences of cottage ownership. However, a proper understanding of these common pitfalls can help avoid unexpected surprises down the road and let you enjoy those quiet moments in your Muskoka chairs.