Blog: Beware the Taxman! A residence left in a trust could be subject to capital gains.September 11th, 2017
In a second marriage, it is common for one spouse to own the matrimonial home. In many cases, that spouse may even have brought the house into the marriage. They plan on living in the home during their lifetime and will typically provide that their second spouse use and enjoy the home after their death. This is done by leaving the home to a testamentary trust created in their will. The trust provides the surviving spouse with the right to enjoy the property but they are not the legal owner. Ultimately, on the death of the surviving spouse or when they decide to vacate the property, the property passes to children of the first spouse.
Capital gains tax was seldom an issue with this type of planning. The property passed into the testamentary trust tax-free and the principal residence exemption sheltered the property while it was in the trust. New changes announced last year may prevent the use of the principal residence exemption and result in a significant tax bill for the family.
In October 2016, the Department of Finance announced some significant tax changes involving the principal residence exemption. Under both the old and new rules, this exemption can exempt the capital gain on a property. For a Canadian resident, the exemption is determined by the formula:
1+ Number of designated years that qualify/total number of years of ownership x capital gain.
The exemption must now be made by filing a form in the year the property is sold to designate, on a year-by-year basis that the property qualifies for that year. To qualify, the following conditions must be met:
- The owner must alone or together with a spouse, own the property during the relevant year;
- The owner must ordinarily inhabit (i.e. inhabit for regular periods of time) the property during the year;
- No other property must be designated for that year.
- In the case of a trust that holds the property, the trust must have a beneficiary who is beneficially interested in the trust, and that beneficiary must ordinarily inhabit the property for some period in the year and designate that the property be his/her principal residence for that year.
In the past, all testamentary trusts potentially qualified as long as there was a beneficiary (i.e., the second spouse) living in the property for a portion of each year, and the second spouse’s principal residence exemption was available.
Beginning October 3, 2016, only qualifying spousal trusts are eligible to make the principal residence designation. To be a qualifying spousal trust, the property must vest indefeasibly in the trust within 36 months of the death of an individual. All of the income of the trust must be paid or payable to the spouse beneficiary during their lifetime. The spouse beneficiary must be the only person with the right to the use and enjoyment of the property during their lifetime.
Many trusts created for second spouses can be drafted to be spousal trusts. However, it is not uncommon that the first spouse may want to add conditions into the trust. For example, if they say that in the event of a remarriage or co-habitation by their surviving spouse, the surviving spouse must vacate the property. Further, at that time, the property is to pass to the children. With these conditions, the trust will not be a spousal trust because the children will have use and enjoyment of the property during the lifetime of the second spouse. Without the principal residence exemption, when the children sell the property they probably will have significant capital gains tax to pay. The years the property was held by the trust will not qualify for the designation.
A word to the wise: If you are leaving a residence into a testamentary trust for your spouse, review the wording of your trust with one of our tax accountants and your lawyer. You may have some tough decisions to make between the terms you want in the trust and the tax results!
Connect with the Author
Karen Slezak, CPA, CA, CFP, TEP, Partner, Tax
Karen is a partner with Crowe Soberman’s Tax Group, member of the SuRE Group and co-leader the firm’s Estates and Trusts Group. Karen has extensive experience in estate and succession planning and corporate tax planning for privately-owned businesses. Connect with Karen via email firstname.lastname@example.org or directly at 416.963.7109.
Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article.