Answer client questions about the Principal Residence Exemption and trusts

When creating their estate plans, many Canadians consider using living, or inter vivos, trusts. Since assets transferred to the trust would normally bypass the settlor’s estate, the trusts can be effective in reducing estate administration (a.k.a. probate) fees, avoiding complex estate settlements and ensuring confidentiality when the settlor dies.

These benefits can extend to a principal residence transferred to the trust and, where possible, when combined with the principal residence exemption (PRE), can be a tax-efficient way to achieve multiple objectives.

Read: How new Principal Residence Exemption rules affect trusts

But how do new PRE rules introduced in October 2016 change things?

To find out, consider the following example.

Kelsie, age 70, is a widow with two children. As part of an estate plan, she is considering an alter ego trust, a type of living trust available to seniors age 65 or older. Her plan is to transfer her assets – particularly those that would otherwise be subject to estate administration fees – to the trust to achieve efficiencies and simplify her estate’s settlement after she dies. One of the assets she’ll transfer to the trust is her home, a property that has been her principal residence for the last 30 years.

Kelsie can transfer assets to an alter ego trust without immediately triggering capital gains taxes. And, from that point forward, the trust would own the assets. However, future income and capital gains from the assets will be taxed in her hands until her death; after her death, they’ll be taxed to the trust at the top marginal tax rate applicable to most trusts.

In considering the transfer, Kelsie has the following questions:

• If she transfers her home to the trust, given that the trust will then own the home, will the PRE continue to be available to shelter the home from tax?
• If the home does not fully qualify for the PRE at the time of a subsequent sale, who would be taxed on any resulting gain: Kelsie, at graduated tax rates, or the trust at the top marginal rate?
• If the trust still owns the home at the time of Kelsie’s death, will the property be taxable at that time? If yes, who will be taxed: Kelsie, on her terminal return, or the trust?

Subject to conditions, tax legislation has historically permitted trusts to claim the PRE for a qualifying property. Provided that a “specified beneficiary” – one who is beneficially interested in the trust and occupies the home as a principal residence – designates no other property as such, the trust would be permitted to claim the property as a PRE, sheltering it from tax for the years designated. This would be the case even if the ownership period was shared between the settlor and the trust. Since the trust would be deemed to own the home for the entire ownership period, the trust could claim the exemption, even for years prior to the rollover to the trust.

New rules

On October 3, 2016, the Department of Finance announced a number of changes to the PRE rules designed to improve compliance and administration of the tax system. As a part of the changes, the types of trusts eligible to claim the PRE was reduced. Effective January 1, 2017, only these trusts are eligible to claim the PRE:

• spousal or common-law partner trusts;
• alter ego, joint partner or other self-benefit trusts;
• a qualified disability trust (for a spouse, common-law partner [CLP] or child of the settlor provided the spouse, CLP or child is eligible for the federal disability tax credit);
• a trust for the benefit of minor children of deceased parents.

In each case, the beneficiary must be a Canadian resident and, if the trust acquires the home after October 3, 2016, the terms of the trust must specifically provide the beneficiary with a right to use and enjoy the property as a residence throughout the period in which the trust owns the property.

Read: Determining property value for the PRE

Understanding the above, we can answer Kelsie’s questions.

1. If Kelsie transfers the home to the trust, given that the trust will then own the home, will the PRE continue to be available to shelter the home from tax?

Kelsie’s trust will be an alter ego trust, so it will be eligible to claim the PRE in respect of a home transferred to the trust – as long as Kelsie continues to occupy the home as her principal residence and no other home is designated as such. In fact, since the federal Income Tax Act (ITA) deems the trust to have owned the home for each year Kelsie owned it, the home can be fully sheltered from tax for all 30 years of ownership, even if the trust owns the home for only a short period prior to a sale

2. If the home does not fully qualify for the PRE at the time of a subsequent sale, who would be taxed on any resulting gain: Kelsie, at graduated tax rates, or the trust at the top marginal rate?

If the home is not used as a principal residence for each year of ownership – perhaps it becomes a secondary property, or at some point is used primarily to earn rental income – then a subsequent sale of the property by the trust would normally trigger tax. The PRE would be available to the trust for the period the home was used as a principal residence, and capital gains tax would be payable for the period the home was used as a secondary or rental income property.

In other words, if the trust sells the home and only part of the gain can be sheltered by the PRE, the remaining capital gain would be taxable, typically in the hands of the settlor (Kelsie, in this case). With an alter ego trust, any income or gains realized by the trust prior to the settlor’s death are normally taxed to the settlor under section 75(2) of the ITA (similar rules apply to joint partner trusts established for the benefit of a settlor and his or her spouse/CLP). This rule would apply to the net gain resulting from the sale of Kelsie’s home prior to her death, resulting in taxation in her hands at graduated rates.

3. If the trust still owns the home at the time of Kelsie’s death, will the property be taxable at that time? If yes, who will be taxed: Kelsie, on her terminal return, or the trust?

When the settlor of an alter ego trust dies, the trust is deemed to dispose of the trust’s assets at the end of the settlor’s death date. This results in taxation of any gains to the trust at the top tax rate, which applies to most trusts. If Kelsie’s home is owned by the trust at the time of her death and the PRE cannot be used to fully shelter the home from tax, the net gain would be taxed to the trust at the top tax rate for the province in which the trust resides.

Conclusion

Trusts are commonly considered in estate planning. In light of recent changes to both the taxation of trusts and the PRE, understanding the new rules will allow financial advisors and clients to better understand the pros and cons of certain trust-related strategies.

Wilmot George

Tax & Estate

Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning at CI Global Asset Management. Wilmot can be contacted at wgeorge@ci.com.