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.
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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.
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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.
If your clients are the settlors and beneficiaries of the trust, they’re in for a big tax bill if they receive the trust’s assets. So make sure that doesn’t happen.
The roll out
Say it’s year 19 of the trust. The clients have had their fill of cottage country and are ready to pass the property on in equal shares to their three kids — now in their 50s.
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This is done using a trustee’s resolution: a document spelling out their intention to pass the cottage on to their children in equal shares.
The next step is land title transfers to the beneficiaries. There’s a separate title for each beneficiary, which indicates the size of his or her ownership interest. (This process is similar to transferring the title of an ordinary residence.)
Pedersen says the property owners would likely avoid running afoul of the 21-year rule without taking this second step. But it’s best not to take any chances — seal the deal with land title transfers just in case CRA raises any questions.
Sorting out the soft issues
A discretionary trust also buys cottage owners some time to sort out key issues.
Say the owners are 55 and have three children in their early 30s. None have their own kids yet. It might be unclear which, if any, of the kids will have the wherewithal to use and maintain the cottage, and keeping it in the trust delays having to decide which ones.
But Pedersen advises that once it’s clear which children will take over, an agreement needs to be drawn up to avoid conflict.
If one of the children lives too far away to use the cottage, she could sell her share to her siblings, or the parents can leave her other assets in lieu.
But what if 15 years pass and it turns out none of the kids are interested in the cottage? If the parents are adamant the cottage stay in the family, they could name their grandchildren as beneficiaries. This will delay the capital gain until the grandchildren sell. They also must be adults to do that.
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The cardinal rule
Letting 21 years pass without rolling the cottage out to a beneficiary or selling it can squeeze a client’s finances.
Pedersen explains one of the cardinal rules of tax-efficient estate planning is “ensuring that tax isn’t triggered until you have the money available to fund it.”
The client who misses the deadline doesn’t have the inflow of cash from a sale, which would be used to pay the tax. He now must dip into other assets to cover the bill.
Turn properties into nest eggs
If clients are buying recreational properties, here are some items to consider.
Property taxes: Regularly reassessing your client’s overall finances throughout the year will help him get a sense of whether the property is still within his financial range.
Renting: Renting the property out to non-cottage owners and travelers can be a great way to generate extra income, which can then be reallocated to cover maintenance costs.
Renovations: Consistent maintenance leads to a better quality cottage that has the potential to sell at a higher value.
Fractional ownership: Consider sharing property ownership with other investors. Your client pays an annual fee that covers the fractional ownership and maintenance, and can enjoy the cottage per the fractional ownership agreement.
Since it’s a portion of the cost, he has the option of re-investing the money he’s saved on RRSPs, GICs and other revenue-generating investments.
Travel expenses: If he plans to use the cottage often, think about where it’s located. Will he need to fly, or can he drive? If he plans on visiting often, gas and flight costs can quickly add up.
Asset vs. profit: If he plans on holding the cottage for generations, he may be looking for unique retreats that aren’t necessarily real-estate hot spots. But if he’s investing as a revenue generator in the short term, tell him to look for up-and-coming cottage property on the waterfront.
Maximize the Principal Residence Exemption
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Under the Income Tax Act, each family unit can designate one property per year as its principal residence. A family unit consists of the taxpayer, the spouse or common-law partner, and any children under the age of 18. The PRE allows them to claim a capital gain exemption for some or all of the years they lived in the home. They must share the exemption. The PRE applies to the building and up to one-half hectare (or 1.2 acres) of subjacent and adjacent land. If there’s more land, the owner must prove it’s required for the taxpayer’s use and enjoyment of the property.
The PRE can apply to any property that’s ordinarily inhabited by the person (and his or her family) during the year, provided it’s not primarily used to earn income. There’s no statuatory definition of “ordinarily inhabited,” but the CRA has said residing in a property for “short periods of time” will qualify.
So many clients who own secondary properties can choose which property they claim.
A personal trust can designate a property held within it as a personal residence and still be eligible for the PRE.
The person using the property as the principal residence must be a specified beneficiary of the trust. And either he, his spouse or common-law partner, his former spouse or common-law partner, or child must ordinarily inhabit the property.
For the trust to designate the property a principal residence, no corporation or partnership could have been beneficially interested in the trust any time during the year.
When the PRE is used by a trust, no specified beneficiary or member of his family can designate another property as a personal residence at any time during the calendar year the exemption is used.
Jacqueline Power is a tax specialist with Mackenzie Investments.