Avoid high tax on old trusts

It’s time to start thinking about any properties you put into trust 20 years ago.

Back on February 22, 1994, the federal government eliminated the $100,000 capital gains exemption for individual taxpayers.

The capital gains rate dropped from 75% to 50%. And a $100,000 lifetime capital gains exemption was axed, which had been popular with investors who cashed out stocks they’d planned to sell sooner rather than later.

That same exemption was also 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.

Problem is, that was more than 20 years ago, and if no action’s been taken since then, it won’t be long before the 21-year rule kicks in.

Tax and estate planning expert Yens Pedersen, a Saskatchewan lawyer, walks us through the issue.

The 21-year rule explained

According to the Revenue Canada (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 you miss the 21-year deadline, it’s exactly as if you 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 filing, they will err on the high side. “Then it’s up to [you] to say, ‘No, my numbers are correct, and here is the supporting evidence,’” Pedersen explains.

If CRA isn’t convinced, then it’s time for court.

Frozen 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 and 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 that you could include yourself as beneficiary if you’re in your 50s or 60s and concerned about having enough money for your retirement years.

“It’s possible [your] primary residence won’t turn out to be worth as much as [you] expected, so the trust could be set up to allow [you] to distribute the assets to [yourself],” he explains.

You should also list your children as beneficiaries. That way the property will pass on to them. But the terms of the distribution should be laid out in advance to avoid ugly legal battles.

If you want to include yourself as beneficiary, it’s critical you not be the creator or settlor 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 you don’t have to worry if the relationship turns sour.

What to do now

So what do with that year-20 trust? Let’s say you’ve had your fill of cottage country and are ready to pass on the property in equal shares to your kids — now in their 50s.

This is done using a trustee’s resolution: a document spelling out your intention to pass the cottage on to your children in equal shares.

A discretionary trust can also buy you time to sort things out.

Say you’re 55 and have three children in their early 30s, and no grandchildren. It might be unclear which, if any, of the kids will have the wherewithal to use and maintain the cottage. Keeping it in the trust lets you put off deciding which ones will inherit.

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 you could 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 you’re adamant the cottage stay in the family, you could name your grandchildren as beneficiaries. This will delay the capital gain until the grandchildren sell. They also must be adults to do that.

The main thing is to do something. Otherwise, you’ll get hit with substantial — and avoidable — taxes.