Owning a country or a lakeside retreat may be at the top of many of your clients’ wish lists, but there are hidden costs they should be aware of before turning their wishes into reality.
The vast majority of Canadians who purchase vacation cottages take out mortgages, said Daniel Collison, Investors Group’s Markham, Ont.-based regional director for Ontario. “And depending on its proximity to fire fighters and its accessibility, your client may have to pay a higher rate than in an urban centre.”
“Mortgage rates for properties in remote areas or in communities where there isn’t a quick real-estate turnaround can be a couple of percentage points higher than standard mortgage rates,” added Chris Menard, BMO’s Kelowna-based area manager, specializing in mortgages, for the British Columbia interior.
Faced with this situation, some buyers will opt to take equity out of their city residences, Menard noted, and pay for the cottage with cash.
Your client shouldn’t spend his last dollar purchasing the property, he added, because there are other costs to acquiring a vacation property. “Banks may require a property appraisal to qualify for financing, and an appraisal that would cost $300 in the city may be as high as $1,000 if the appraiser has far to travel,” he said. “The same is true for a home inspection to uncover problems that might not be obvious. It will let him know what expenses he is in for down the road and may enable him to negotiate a lower purchase price.”
A buyer will also have to pay a lawyer to conduct searches on the property and draft the title deed. And in most provinces, buyers have to pay land transfer tax.
“There will also be hook-up fees charged by utility and phone companies. And property tax adjustments if the seller has already paid his taxes,” Menard said.
“A vacation property means that your client will have to double up on all the expenses he has in the city – hydro, phone, cable, internet, perhaps heat as well,” Collison said.
The client will also need to take out home insurance. Collison noted that the cost of insurance will be higher if a property is far from fire fighters or is fairly inaccessible, such as a cottage that is located on an island. If your client has a mortgage, the lender will insist on enough insurance to cover the cost of rebuilding if the home should be completely destroyed. Home insurance prices are based on the value of the home and current reconstruction costs.
“If your client plans to rent the cottage, he’ll need to inform the insurer who will factor liability into the insurance cost,” Collison added. “There are also advertising costs to consider, and the cost of cleaning the premises between tenants.”
Your client may need another lawn mower, another snow blower and another toolbox, Menard said. “Or he may have to hire people to mow the lawn, plow the drive and do repairs.
Menard suggested starting cottage life with as much as $5,000 in a rainy-day fund to cover unforeseen repairs and purchases.
And there may be hefty bills farther down the road. At some point, roofs, septic systems, docks and decks may have to be replaced. A well may go dry and a new one will have to be drilled.
“And then there are the expensive toys your client will want at the cottage,” Collison said. “The power boats, the all-terrain vehicles, the snowmobiles. And don’t forget that licences, insurance and boating safety courses are required to operate power boats.”
There are also the costs of travelling back and forth to the vacation property, he noted. “Gas for the client’s vehicle and a trailer for the boat.
“And there will be the cost of entertaining,” he added, “because everyone your client knows will want to spend a weekend at his cottage.”
When your client grows older, he may decide he’s no longer up for the travel, work and expense of cottage living. But selling a vacation property can take time, which could pose a problem if a quick sale is required. “The duration of vacation properties on the market is longer than properties in urban centres,” Menard said. “They can take a while to sell.”
Collison also noted that vacation properties are among the first properties to drop in value in real-estate market downturns, along with condos and high-end city homes. “They are a market unto themselves.”
Vacation properties have soared in value in recent decades, and a property that your client’s father bought for $10,000 may now be worth $1 million. Because the cottage is not your client’s permanent residence, that huge appreciation in value is a capital gain and will be subject to capital gains tax when the property is sold.
In calculating the cottage’s appreciation, your client can subtract the cost of improvements he has made over the years. Hopefully, he has kept receipts. If he, or his parents, have done most of the work themselves, “he might want to make an argument to the Canada Revenue Agency based on before-and-after photos,” said Christine Van Cauwenberghe, assistant vice-president of tax and estate planning at Investors Group in Winnipeg.
The client may be able to make use of the principal residence exemption, which exempts the appreciation in value of the principal home from capital gains tax, she added. Even cottages that are occupied only on a seasonal basis may be designated principal residences for purposes of the exemption. To make the designation, the client will need to file Form T2091(IND) with the Canada Revenue Agency.
If your client has owned his vacation property for many years – he may have inherited it – he will probably want to pass it on to his children or grandchildren. But if he gifts it to a child during his lifetime, even though there is no sale, there is no escaping the capital gains tax. The gift is considered a “deemed disposition” at market value, triggering the tax when the property changes hands.
“The worst-case scenario is if your client leaves the cottage to his children in his will, and after his death they realize that they owe $500,000 in capital gains tax,” Menard said. “And they have to sell the cottage to pay the tax.”
As a trusted financial advisor, you need to make sure that your client understands what his children will want to do with the cottage when he can no longer cope with it or after his death, Van Cauwenberghe said. “Do the kids really want the cottage? Do they all want it? Can they afford to maintain it? And how will they deal with the capital gains tax?”
Often one child will want to keep the cottage in the family and another child won’t want anything to do with it, she said. “In this case, you will need to figure what the value of your client’s estate will be on an after-tax basis. Will there be enough other assets to equalize the inheritance of the child who doesn’t want the cottage?”
If there are enough assets in your client’s estate, they can be used to pay the capital gains tax on the cottage, she said. “Or the client can take out life insurance to pay the tax after his death. Or the children can take out life insurance on the client and they can pay the premiums.”
If life insurance is a strategy your client favours, he will need to factor the cost of premiums into his operational expenses while he is maintaining the cottage. “And he shouldn’t wait too long to purchase a policy,” Van Cauwenberghe said. “He may not be eligible after a certain age.”
After your client’s death, she said, the children should own the cottage as tenants in common. They will need to draw up a co-ownership agreement that details what will happen if one sibling dies, if a sibling and his spouse should divorce, and when each tenant can use the property.
Van Cauwenberghe favours tenants-in-common ownership over transferring the cottage to a trust. “Setting up and maintaining a trust is expensive,” she said, “and there is a deemed disposition every 21 years, when capital gains taxes will have to be paid on accrued gains.”