QUESTION:
How do I establish FMV on an inherited cottage?
ANSWER:
A client recently approached us about a cottage they had just inherited. They hoped to keep the property in the family, but were unsure of the associated tax burden and wondered how to establish the cottage’s current value in an unpredictable market without selling.
Capital gains on secondary residential properties
When a person dies in Canada, the majority of their assets are considered to have been ‘sold’ at the current fair market value (FMV). The Canada Revenue Agency calls this a ‘deemed disposition’—the proceeds of which are used to calculate the capital gain received by the beneficiary.
Note: Exceptions include property transferred to an eligible surviving spouse (deemed disposition at cost), and the deceased’s principal residence (capital gain is exempt from tax for the years the property is designated as a principal residence).
For a secondary residential property like a cottage, the capital gain represents the difference between the adjusted cost base of the property (original purchase price including fees, plus any capital improvements) and the FMV at time of death.
Half of this capital gain would need to be included in your total income on your tax return and would be taxed at your marginal tax rate.
As an example: If your parents purchased the cottage in 1980 for $150,000, spent $250,000 on eligible capital improvements, and the cottage is now worth $1M—the capital gain would be $600,000, of which $300,000 would be considered taxable income.
How is current FMV on an inherited cottage determined?
If you elect to sell the cottage, its current value will be set by the sale price. The capital gains calculation then becomes relatively straightforward, assuming that records have been kept of the original purchase and any capital improvements.
If you elect to keep the cottage, you still need to determine the current FMV of the property in order to report the capital gain.
Note: Although you won’t need to provide proof of the property’s current value when you file your taxes, the onus will be on you to supply reasonable documentation at the CRA’s request.
There are two common ways to determine a property’s current FMV in this situation.
If the cottage’s estimated value and associated capital gain are relatively modest, a letter or current market assessment (CMA) from a realtor providing an estimate of a property’s current value (based on recent sales of similar properties) may suffice. This type of report is basically the same as what a realtor would provide when listing a property for sale.
If the cottage’s estimated value and associated capital gain are more significant, or if you have any reason to believe a market assessment would not accurately reflect the real estate’s value, it may be worth paying for a professional appraisal.
Both the Canadian National Association of Real Estate Appraisers (CNAREA) and the Appraisal Institute of Canada (AIC) are responsible for licensing and certifying appraisers in Canada. They provide search feature on their websites that can help you locate an accredited appraiser in your area.
Note: The assigned FMV value of the cottage accepted by the CRA will then become your cost base moving forward.
Establishing capital improvements without proper records
One challenging aspect when inheriting a family cottage tends to be establishing the cost of older capital improvements, as many people fail to keep proper records.
We recently had a situation where hundreds of thousands of dollars had been spent renovating and rebuilding a cottage inherited by a client, but no proper records had been kept. Luckily, we were able to get agreement with the CRA on a reasonable estimate of the construction costs using old family photos. In this type of situation, the more documentation you can pull together to help make your case to the CRA, the better.
Additional information on capital improvements can be found in our Insight Capital gains and cottage ownership – what you need to know.
Vacation property outside of Canada
Canadian tax applies to all of your assets worldwide. If an inherited property is located outside Canada, you may be subject to taxation in the country where the property is located in addition to Canadian capital gains tax.
An exception to this is property located in the United States. Canada and the United States have a very friendly tax treaty whereby the estate tax paid to the IRS is credited against the capital gains tax payable in Canada. But if you own (or believe you may inherit) property in another country, we strongly recommend that you seek professional advice on the foreign tax implications, as there may not be tax credits available and you may end up paying tax in two countries on the same property.
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