If you have clients who put properties into trusts 19 years ago, you have work to do.
Back on February 22, 1994, the federal government eliminated the $100,000 capital gains exemption for individual taxpayers.
CRA cut the capital gains rate to 50% from the prior 75%. But it also nixed a $100,000 lifetime capital gains exemption popular with investors who cashed out stocks they’d planned to sell sooner rather than later.
That same exemption was popular among Canadians who wanted to offset increases in the values of inherited vacation properties. They’d use the remaining exemption as part of a strategy to pass on the family cottage to their children or grandchildren.
Owners placed the property in a discretionary trust and triggered a capital gain. But with their remaining exemption room they were able to avoid paying tax for the transfer.
Problem is, that was 19 years ago, and if no action’s been taken in the interim, it won’t be long before the 21-year rule kicks in.
Tax and estate planning expert Yens Pedersen, an associate at Miller Thomson in Toronto, walks us through what your clients face.
The 21-year rule
According to CRA, property held in a trust is deemed to be sold every 21 years, unless it is actually sold or rolled out to beneficiaries before the 21-year deadline.
For tax purposes, if your clients miss the 21-year deadline, it’s as if they sold the cottage. That means capital gains tax.
The deemed sale value will be the property’s fair market value at the time the 21-year period ends. Capital gains are then calculated based on that amount, minus the value of the property when it entered the trust.
If no action is taken before then, CRA will audit and assess the trust. “And the CRA doesn’t like to leave money on the table,” Pedersen warns.
If the authorities find something inaccurate in your client’s filing, they will err on the high side. “Then it’s up to the taxpayer to say, ‘No, my numbers are correct, and here is the supporting evidence,’” Pedersen explains.
If CRA is not convinced, then it’s time for court. This is why it’s important to have a professional appraisal of the property when it enters the trust. That shows you’ve made a good-faith effort to determine fair value.
A trust freezes the value of the property for 21 years, so beneficiaries will get the cottage at the same value it entered the trust. So beneficiaries inherit the property without triggering a tax bill. Capital gains are deferred until the beneficiaries decide to either sell the property or place it in a trust for their children.
Pedersen notes the property owners could include themselves as beneficiaries if they’re in their 50s or 60s and concerned about having enough money for their retirement years.
“It’s possible their primary residence won’t turn out to be worth as much as they expected, so the trust could be set up to allow them to distribute the assets to themselves,” he explains.
But they should also list their children as beneficiaries. That way, when the parents die the property will pass on to them. But the terms of this distribution must be laid out in advance to avoid ugly legal battles.
If the property owners want to include themselves as beneficiaries, it’s critical they not be the creators or settlors of the trust, Pedersen says. “If the creators of the trust are also beneficiaries, they can’t roll the property out to themselves on a tax-deferred basis.” A common strategy is to have a friend be the creator of the trust. “Once the trust is established, the friend has no further role,” so the cottage owners don’t have to worry if the relationship turns sour.