Residence exception rule changes impact capital gains taxes
By Paul Russell, AdvocateDaily.com Contributor
Changes in the last few years concerning trusts and the principal residence exemption have fundamentally altered the estate planning process, says Toronto wills and estates lawyer Mary Wahbi.
“The use of the principal residence exemption by a trust has been narrowed since 2017,” says Wahbi, a partner with Fogler Rubinoff LLP. “Clients need to appreciate that there may be some capital gains tax to pay when that property is finally sold because it could be in the type of trust that doesn’t qualify for the exemption.”
Up until 2017, parents who owned a home together could include a trust for the property in their wills, she says, giving the example of one that specifies that once the second spouse dies, the home will be held for their children until the youngest one finishes a university degree or reaches the age of 25, whichever comes first.
If one spouse were to die, the home would be transferred to the surviving spouse on a rollover basis, with no tax consequences, Wahbi tells AdvocateDaily.com. On the death of the second spouse, no taxes would be payable on the growth in value of the home because their exemption would still apply to the trust.
Any increase in the home’s value could be sheltered from taxes by the trust claiming the principal residence exemption, she says, with the trust using the exemption by designating one or more “specified beneficiaries” who ordinarily inhabited the property. The home could then be sold at its increased value, and all of the proceeds would be tax-free.
Wahbi says as of 2017, new rules restrict the availability of the exemption to trusts. The exemption is now only available to alter ego trusts, joint partner and spousal trusts, a qualified disability trust, or a trust for minor children of a deceased parent.
“We now have to explain to clients that there’s a very good chance that increase in value may not be sheltered, with taxes payable at the end of that trust,” she says, adding that if the home is in Toronto, that increase in value could be significant.
In the example used above, Wahbi says the growth in the value of the home from the time the child is 18 to 25 will not be sheltered.
“There are ways around this rule, but it involves one of the kids receiving the home as part of their interest in the estate and using his or her own principal residence exemption for all of those years on a later sale,” she says.
Wahbi says that could cause problems with the other siblings, or not fit into the overall estate plan, especially if there aren’t sufficient assets to equalize the gift. This also applies to cottages held in a family trust.
“Typically, the idea is that the property can be sold and the proceeds divided between the children, but the new rules make that difficult without incurring tax unless careful planning is undertaken,” she says.
Wahbi says there were good reasons for the government to bring in the new rules.
“Frankly, there was a great deal of abuse of the principal residence exemption before 2017,” she says. “It was easy to claim as you didn’t have to file anything with your tax return.”
People took advantage of the exemption by flipping their home every few years, Wahbi says, which didn’t technically qualify for the exemption.
“People would live in a house for two or three years while they renovated it, and then sell it and go to the next one, and that was actually their source of income,” she says. “They never paid a penny of tax on it, as they treated it as exempt and it was difficult to catch.”
The other abuse targeted was the use of the principal residence exemption by non-residents. The new rules have addressed both situations, Wahbi says, by adding filing requirements when a property is sold, which will capture flippers and by eliminating the “plus-one rule” for non-residents, thereby preventing a non-resident of Canada from buying and selling a property in the same year without paying tax.
“While the goals were sound, the government went a bit too far by narrowing the use of the exemption in the case of trusts,” she says.
Wahbi says spousal trusts that qualify for the principal residence exemption have to be qualifying spousal trusts, which require that the capital of the trust be held for the lifetime of the surviving spouse, common-law or married.
“All the income created by that trust, if there is any, has to be paid to the spouse and the only person that can be entitled to any of the capital of that trust is the spouse,” she says. “It cannot be paid to anyone else, and it has to be for his or her lifetime.”
Wahbi says one of the more complicated estate planning scenarios arises with second marriages, especially when one or both partners have children, and they want the children to inherit their estate while making some limited provisions for their new partner.
“So a trust that previously made sense for the surviving spouse in that scenario said something like, ‘Hold my house for the lifetime of my spouse, but if she or he remarries, the home has to be sold and the money given to my kids,” she says.
“Or in many instances, the will and marriage contract allows the surviving spouse a specific period of time to reside in the house or hold it until the surviving spouse has to go to a retirement facility,” Wahbi says. “That type of trust will not qualify for the exemption now because it is not for the lifetime of the surviving spouse and the client needs to appreciate that the growth in value of that home will be taxable if no further planning is done.”
Wahbi urges people to work with an estate lawyer and set up the trust that best suits their circumstances.
“It’s a little bit of work, but it’s worth it in the long run,” she says.