As Budget 2017 reminded us, new Principal Residence Exemption (PRE) rules have been in effect since October 3, 2016. Those rules changed reporting requirements and excluded non-residents from certain provisions.
But it’s the new rules around trusts and principal residences that will cause “the most consternation for planners,” said Ian Lebane, a tax and estate specialist with TD Wealth Private Client Services, at a webinar held by the Society of Trust and Estate Planners (STEP) in March.
During the webinar, Lebane detailed what advisors need to know.
Only certain types of trusts can claim the PRE
Under the new rules, only three types of trusts are eligible to claim the PRE:
- Life interest trusts, or as Lebane explains, “trusts that would benefit from a rollover, generally speaking.” These trusts are:
- alter ego trusts;
- spousal or common-law partner trusts;
- joint spousal or common-law partner trusts; or
- certain trusts for the exclusive benefit of the settlor during the settlor’s lifetime.
- Qualified disability trusts (QDTs)
- A trust created for a minor child of the settlor
Those trusts can only have certain beneficiaries
Having only three trust types is restrictive, but the rules are even more specific. The trust will only be eligible if the beneficiary is:
- resident in Canada during the year, and
- if the trust acquires property after October 2, 2016, “the terms of the trust must provide the beneficiary with a right to the use and enjoyment of the housing unit as a residence throughout the period in the year in which the trust owns the property.”
Regarding the trust terms, “that’s not how many trusts are drafted now,” says Lebane. But for “any wills where the testator is still alive, they need to have that language.”
Further, each type of trust has its own beneficiary requirements.
For life interest trusts, the beneficiary can only be the settlor, or the spouse or common-law partner or former spouse or common-law partner of the settlor.
For the QDT, the beneficiary must elect to benefit from the QDT, and he or she must be the spouse or common-law partner (or former spouse or common-law partner), or a child of the settlor. Further, the beneficiary must qualify for the Disability Tax Credit.
For the minor child trust, the beneficiary must be the child of the settlor, and both parents (including the settlor) must be dead before the start of the year.
Problems that can arise
Life interest trusts
Lebane points out a few concerns for life interest spousal trusts.
It’s only possible to claim the PRE “if the right to occupy is unconditional for the spouse’s lifetime,” he says. Yet it’s common for trusts to place conditions on the spouse’s living in the house, such as only being able to live there if they do not remarry, or specifying that the spouse must pay for utilities and upkeep. “These things would put a trust offside because that’s a quid pro quo,” says Lebane.
And even if the right is unconditional, the trust will be offside if it directs sale proceeds of the property to any other beneficiaries while the spouse is still alive. Lebane also points out that if there is a large age difference between the surviving spouse and the deceased spouse, it could be many years before the spouse dies and the sale proceeds can be directed to other beneficiaries.
In short, the trust terms must mandate both the unconditional right to occupy and that “the proceeds received by the trust must remain available to the spouse, and only to the spouse, for the remainder of her life,” says Lebane.
People can benefit from only one QDT at a time, which can restrict planning. “If the principal residence is held in one [trust] and the investments are in another, you have a choice to make” as to which trust to benefit from, Lebane points out.
He says the investment trust could use the preferred beneficiary election (PBE), which would allow the trust’s income to be taxed in a disabled beneficiary’s hands, even if it’s not paid out to them (read more on this here).
And Lebane reminds us that beneficiaries of QDTs must qualify for the Disability Tax Credit (DTC). If the intended beneficiary hasn’t qualified for the DTC yet, he recommends initiating the process now.
Minor child trusts
Lebane points out that many trusts for children are intended to continue after they turn 18, including principal residence trusts. “We all know what’s going on with older kids in university. They’re not leaving home at 18 […] or [even] 25, I dare say. But if they’re living in the house and they are over 18, the trust becomes ineligible.”
He adds that an asset as valuable as a family house can be a big responsibility for an adult child to own outright.
Another wrinkle: the minor child trust is ineligible if one parent is alive, “regardless of the relationship with the child,” says Lebane. One might assume the child can move in with the living parent, but Lebane points out that parent could be estranged or unable to house the child.
“The [options for] trusts for minor children are quite narrow,” he says.
Getting in compliance
If you have clients whose wills create principal residence trusts, make sure the language within the will complies with the October 2016 rule changes. Lebane suspects that many documents will be offside.
“When the death is after 2016, the trust has to specifically contain the use and enjoyment language” mentioned earlier, he emphasizes.
But if the testator is incapable, it can be difficult to change the language. Court cases have allowed attorneys for property to settle joint partner trusts (see our article, “Creative planning for incapacity,” for more on this), but Lebane says getting court approval is the safest option. If the testator dies, he says post-mortem planning is limited, but can include going to court for a wills variation.
If there’s no way to make an ineligible trust eligible for the PRE, Lebane says the Income Tax Act permits the trust to roll out the property to a capital beneficiary who will “be deemed to have owned the principal residence for the years the trust owned it.” He cautions, however, that this is not possible for all beneficiaries. Further, while this tactic may work for tax reasons, often “it’s not what the testator planned at all. And now you have large funds in the hands of the beneficiary, which is often contrary to the point of the trust.”
Last resort? The trust can claim the PRE until the end of 2016, and any subsequent increases will be taxable. Lebane suggests that those involved with ineligible trusts obtain a valuation for the property as of the end of 2016. That way, there will be “a certain value that will be sheltered” by the PRE.
Lebane also notes the following:
- For tax year 2016, CRA has said it would assess PRE filing penalties in only “the most excessive cases.” Says Lebane, “I don’t know what excessive means, but I think there’s just more leniency.”
- The new PRE rules eliminate the one-plus rule for non-residents (read more about that here). Lebane points out that “if a spouse or adult child is already in Canada, [the non-resident] could make a gift of cash to that person, who could buy it.” That way, a resident would purchase the property and the one-plus rule could apply.