We sold our house and now rent – can we sell our cottage tax-free?

High on the list of all-time most popular personal finance topics are strategies for selling or passing down the family cottage. Cottages can be treasured family heirlooms – that’s one reason. Another is tax-related.

It’s widely known that you can sell a principal residence without paying tax on your capital gain, which is the difference between the cost and the selling price. But if you own a cottage in addition to a house, you can only designate one dwelling as a principal residence. This is why cottages keep generating tax-related questions from readers.

Here’s a sample recently submitted by a reader of this newsletter: “We are seniors and we sold our home four years ago. We live in an apartment for six months of the year, and the other six months we live in our cottage. When we sell the cottage, will we have to pay capital gains?”

For help with this question, I consulted Peter Guay of PWL Capital in Montreal.

Mr. Guay assumed for his answer that this reader and her partner did not pay tax on the home sold four years ago because they used their principal residence exemption. “Based on that assumption, they will have to pay capital gains tax on a portion of the gain in value of their cottage,” he wrote in an e-mail. “They won’t pay tax on the gains of the last four years because it was their only home during that period and they can use their principal residence exemption. The cottage qualifies [for the exemption] because the couple regularly inhabited it and did not own it primarily for the purpose of generating income.”

Mr. Guay said the couple will pay tax on the gain in value during the time they owned both homes concurrently. This is because they already used their principal residence exemption for those years against their city house.

To determine the portion of the gain that will be subject to tax, Mr. Guay said they should calculate the total gain in value since they bought their cottage and multiply that by the number of years they owned both properties (minus one year), then divide that by the total number of years they owned the cottage.

Mr. Guay concluded with some tax-filing tips. First, the taxable portion of the gain will have to be reported on Schedule 3, Capital Gains (or Losses) of their federal tax return and the equivalent form for their province, and they will also have to complete Form T2091(IND), Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust).