On October 3, 2016, amendments were announced to the Income Tax Act that have a critical impact on the ability of some trusts to claim the principal residence exemption. These changes are discussed in more detail below. If your estate plan includes a trust that currently holds or may in the future hold a residence and the trust:
- (a) does not qualify for tax purposes as an alter ego trust, common-law partner trust, spousal trust, joint spousal or common-law partner trust or qualifying disability trust;
- (b) is not a trust for the benefit of a minor child whose parents are deceased; or
- (c) is a trust described in (a) or (b) but does not expressly provide the primary beneficiary of the trust with the right to use and enjoy a residence held by the trust and there is a possibility that the trust may acquire a residence on or after October 3, 2016;
then it may be advisable to make certain changes to your estate plan. The amendments take effect for 2017 and subsequent taxation years. As a result, if changes to your estate plan are required, they should be completed as soon as possible.
Current Rules - Applicable for 2016 and Earlier Taxation Years
Currently, a personal trust may be able to designate for tax purposes a property held in trust as a principal residence for a year.
In order for a trust to claim the principal residence exemption in respect of a property owned by it, the property must be ordinarily inhabited by a "specified beneficiary" of the trust in the year and no partnership or corporation may be beneficially interested in the trust in the year. The term "specified beneficiary" is defined in the Income Tax Act and includes any beneficiary of the trust who ordinarily inhabited the property during the year or who has a spouse, former spouse or child who ordinarily inhabited the property during the year. The term "ordinarily inhabited" for these purposes is given a fairly broad interpretation and may include the seasonal use of a recreational property such as a cottage.
The designation of the property as a principal residence by the trust for a year results in the property being deemed to be the principal residence of every specified beneficiary of the trust for that year. Because the Income Tax Act only allow taxpayers to designate one principal residence per family unit, the spouse and minor children of a specified beneficiary will also be unable to claim the principal residence exemption in respect of other property for that year.
If the trust designates the property as a principal residence for the years it has owned it, then any capital gains arising in the trust from the sale of the property by the trust will be exempt from income tax.
Instead of selling the property, the trustees may decide to transfer the property in kind to a beneficiary of the trust on a tax-deferred basis pursuant to subsection 107(2) of the Income Tax Act. In this case, subsection 40(7) of the Income Tax Act deems the recipient of the property to have owned the property continuously since the trust acquired it for purposes of the principal residence exemption. This means that the beneficiary receiving the property may personally designate the property as his or her principal residence for the years the property was held in trust, provided the other requirements for making the designation are met (e.g. that the beneficiary or his or her spouse or child ordinarily inhabited the property for all years in respect of which the designation is made).
Proposed Amendments - Applicable for 2017 and Subsequent Taxation Years
The proposed rules add additional eligibility criteria that a trust must meet before being able to designate a property as a principal residence. For each tax year after 2016, a trust must be a spousal or common-law partner trust, joint spousal or common-law partner trust, an alter ego trust, a qualifying disability trust or a trust for the benefit of a minor child whose parents are deceased in order to claim the principal residence exemption. In addition, the following person must be a specified beneficiary of the trust:
- In the case of an alter ego trust, the settlor;
- In the case of a spousal or common-law partner trust, the spouse who is the income beneficiary of the trust during his or her lifetime;
- In the case of a joint spousal or common-law partner trust, either or both of the spouses or common-law partners;
- In the case of a qualifying disability trust, the electing (i.e. disabled) beneficiary; and
- In the case of a trust for the benefit of a minor child whose parents are deceased, the minor child.
In addition, the specified beneficiary must be resident in Canada for each year the designation is made. Finally, if the property was acquired on or after October 3, 2016, the terms of the will or other document establishing the trust must expressly provide the specified beneficiary with the right to use and enjoy the property as a residence throughout the year.
A beneficiary to whom a residence is distributed in kind by the trustees on a tax-deferred basis will continue to be deemed to have owned the property for the years that it was owned by the trust for the purposes of the principal residence exemption.
It is important to note that the proposed amendments apply for 2017 and subsequent taxation years. Accordingly, a trust which has made a principal residence designation in respect of a property for 2016 and earlier tax years will continue to have capital gains attributable to those years sheltered on the disposition of the property by the trust.
Does Your Estate Plan Need Review?
As mentioned above, not all estate plans involving trusts will be impacted by the new rules. Trusts that qualify as alter ego trusts, common-law partner trusts, spousal trusts, joint spousal trusts, joint common-law partner trusts, qualifying disability trusts or trusts for the benefit of a minor child whose parents are deceased will continue to be able to claim the principal residence exemption, if the specified beneficiary is resident in Canada and either: (i) the document establishing the trust provides the specified beneficiary with the right to use and enjoy any residence held by the trust; or (ii) the trust acquired the residence prior to October 3, 2016, and it is not anticipated that the trust will acquire any additional or substitute residence in the future.
In addition, trusts that are not intended to hold real property which will be occupied by one or more beneficiaries of the trust or a spouse or child of a beneficiary of the trust will not be impacted, as these trusts are not able to claim the principal residence exemption under the current rules.
However, in other cases the proposed amendments may have a significant adverse impact on one's estate plan. By way of example, consider the following scenarios:
- A trust holds a residence for a disabled beneficiary who does not qualify for the Disability Tax Credit. As a result, the trust does not qualify as a qualified disability trust and so cannot make a principal residence designation in respect of the residence. At the same time, it may not be advisable to distribute the property in kind to the disabled beneficiary prior to its sale.
- Parents of a minor child include a trust in their respective wills which provides a child of theirs with the right to inhabit the family home until age 25. Although the trust will be able to designate the home as a principal residence while the child is under age 18, the designation will not be possible for those years that the trust holds the home and the child is between the ages of 18 and 25.
- A testator dies in 2025. She is survived by her spouse and minor children. At the time of her death, she is the sole owner of the matrimonial home and directs that her entire estate be held in a spousal trust. The terms of the spousal trust provide that the spouse will receive all income of the trust during his lifetime and may receive distributions of trust capital at the trustees' discretion, with a direction to preserve the capital of the trust if possible for the benefit of the testator's children. The trust does not explicitly provide the spouse with the right to use and enjoy any residence held by the trust. The spouse advises the trustees that he wishes to downsize to a smaller home. The trust would not be able to designate the matrimonial home as a principal residence. The trustees would be required to consider whether they should distribute the property in kind to the spouse prior to its sale so that the spouse may claim the principal residence exemption personally in respect of the home or whether to sell the home and continue to hold the proceeds in trust in order to honour the testator's wishes regarding the inheritance of trust capital by her children, notwithstanding that this will incur higher taxes overall. If the relationship between the spouse and the children is acrimonious, this situation could exacerbate conflict in the family and increase the risk of litigation.
It is always a good idea to review your will at regular intervals, particularly if you have not done so for a number of years. Now with the significant income tax changes that have been proposed, it is important to do so if your estate plan involves a trust that may be impacted.