The Department of Finance announced significant changes related to the claiming of the principal residence exemption by trusts on October 3rd 2016.
The purpose of this memo is to discuss these changes and to alert the reader as to what can be done to mitigate the effects of these changes on the future claim of the principal residence exemption by trusts and their beneficiaries. However, a taxpayer should consult with their own qualified tax advisors to advise them in their own particular circumstances as every taxpayer’s situation is different.
The current principal residence exemption rules for trusts allow certain trusts to claim the principal residence exemption with respect to a home owned by the trust for the benefit of beneficiaries for a particular year provided certain conditions are met. These include the following:
- The trust designates each individual who was beneficially interested in the trust and who either ordinarily inhabited the housing unit in the particular year or had a spouse or child who ordinarily inhabited the housing unit in the particular year (referred to as a “Specified Beneficiary”),
- No corporation or partnership, other than a registered charity, was beneficially interested in the trust in the particular year,
- The trust designates the particular property as its principal residence for the particular year,
- The trust is a personal trust for the particular year, and
- No other property has been designated for the particular year as a principal residence of any Specified Beneficiary of the trust for the year or by such beneficiary’s spouse or minor child (a child under 18 years of age).
Under the current rules, the trust itself, but not the relevant occupants of the home, must be resident in Canada in order to claim the principal residence exemption. Thus, a trust where the beneficiaries are non-residents of Canada may potentially qualify for the principal residence exemption provided the trust is resident in Canada.
However under the new principal residence rules for trusts, it is now required that in order for a trust to claim the principal residence exemption on a home owned by the trust, the following additional conditions must be met:
- The trust must be a Spousal Trust, an Alter Ego trust or a Joint Spousal Trust created by a person and the person with respect to an Alter Ego Trust, the spouse with respect to a Spousal Trust or the person or his or her spouse in respect of a Joint Spousal Trust [referred to as an “Eligible Beneficiary”] has not yet died before the beginning of the year,
- The Eligible Beneficiary is resident in Canada during the particular year,
- The Eligible Beneficiary is beneficially interested in the trust and ordinarily inhabited the home in the particular year or had a spouse or child who ordinarily inhabited the home in the particular year, and
- If the home was acquired by the trust after October 2nd 2016, the trust terms must provide that the Eligible Beneficiary must have a right to the use and enjoyment of the home owned by the trust as a residence throughout the particular year.
Thus under the new principal residence rules for trusts, the Eligible Beneficiary must be beneficially interested in the trust, must be resident in Canada and must ordinarily inhabit the property in the particular year or have a spouse or child of the beneficiary ordinarily inhabit the property in the particular years the principal residence exemption is claimed.
Certain other qualified disability trusts and principal residence trusts established for the benefit of minor children whose parents are no longer alive may also qualify for the principal residence exemption.
Because of the severe new restrictions placed on trusts to be able to claim the principal residence exemption in respect of a home owned by a trust, there will likely be very few existing trusts which qualify for the principal residence exemption after 2016 when the new rules come into effect.
However, there is a transitional rule which applies to trusts which qualify for the principal residence exemption under the current rules to allow them to be able to claim the principal residence exemption on gains on a home accrued up to the end of 2016 by deeming the trust to have disposed of the home at its fair market value on December 31st 2016 and to have immediately reacquired the property at a cost equal to those deemed proceeds when determining the gain exempt from tax under the principal residence exemption on eventual sale of the home. This will require a trust in this situation to get an appraisal of a home owned on December 31st 2016.
However, any gain on a trust’s home which accrues after December 31st 2016 will no longer be eligible for the principal residence exemption unless it falls within the very narrow exceptions for certain trusts under the new rules.
Assuming the property continues to go up in value after December 31st 2016, in order for a home owned by a trust that does not meet the much more restrictive conditions after 2016 to continue to qualify for the principal residence exemption, the trust may either before December 31, 2016:
- Distribute the home to the beneficiary(s) of the trust at cost
If the trustee distributes the home to beneficiaries resident in Canada in satisfaction of all or part of their capital interest(s) in the trust, the trust will generally be deemed to have disposed of the home for proceeds equal to its cost (so that no gain is triggered on distribution) and the beneficiaries are deemed to have acquired the home at a cost equal to such amount. Furthermore, the beneficiaries are deemed to own the property throughout the period of time it was owned by the trust for purposes of claiming the principal residence exemption on the eventual sale of the home.
- Trigger the gain on the home by distributing the home to the beneficiary(s) of the trust at fair market value
Alternatively, the trust may elect to deem to have disposed of the home at its fair market value on distribution of the home to the beneficiaries in which case it will trigger the inherent gain on the home which may be exempt from tax under the current rules and which will increase the deemed cost of the home to the beneficiaries.
This may be advantageous for the beneficiaries if they are not able to claim the full principal residence exemption or only a partial exemption on the eventual sale of the home because the beneficiaries do not meet the conditions to designate the property as their principal residence for all or some of the years the home was owned by them or the trust and the trust is able to claim the principal residence exemption to exempt the full gain on distribution to the beneficiaries under the current rules.
Of course, there are other reasons to hold a home in a principal resident trust which will be affected by the distribution of the property to the beneficiaries in order for the home to continue to qualify for the principal residence exemption. Most of these reasons relate to protecting the home (often an individual’s most valuable asset) from creditors or potential creditors of the beneficiaries; which could include a marital claim on separation or divorce.
Other reasons to hold a home in a principal residence trust are to avoid probate and succession duties that would be payable on the death of the owner of a home and to avoid possible claims by beneficiaries of the home owner that may arise on death under dependent relief legislation such as the BC Wills and Estate Succession Act. These objectives must also be built into any plan whereby a home owned by a trust is distributed to one or more beneficiaries in order to continue to qualify for the principal residence exemption.
We must also be mindful of the BC Property Transfer Tax and ensure that any plan involving the transfer of legal title to a home will not trigger BC PTT or steps are taken to mitigate triggering this tax. Most transfers of legal title to a property in BC that is required to be registered at the land title office will be subject to BC property transfer tax. Possible ways to avoid BC PTT on the transfer of a home from a trust to a beneficiary may include relying on certain exemptions from BC PTT on transfers between related persons, OR the principal residence trust only distributing the beneficial interest in the home to the beneficiaries and continuing to hold legal title to the home on behalf of the beneficiaries under a bare trust agreement.
Trustees of trusts which own a home which may qualify for the principal residence exemption under the current rules should review these significant amendments to determine what actions need to be taken before 2017 to continue to be able to claim the principal residence exemption post 2016 and to mitigate the effects of these amendments.
Please contact your DMCL tax advisor if you would like us to assist you in interpreting these new rules in your particular situation.