Turning 21 is supposed to be when an angst-ridden youngster comes of age. But with trusts and tax bills, it’s the year when anxiety levels can skyrocket.
The 21-year rule, which applies to most personal trusts, means that a deemed disposition comes into play and the trustee has to file a return on all the property held as if he or she had sold it at fair market value. This means you are triggering, and taxed on, all the capital gains accrued over that time.
When a property significantly goes up in value that can mean a large tax bill and if trustees and advisors don’t plan ahead, that can prove problematic, especially if the cash is not readily available.
There are options, however. Jonathan Braun, manager, tax and estate planning at Investors Group, looks at how clients can negotiate the 21-year rule.
1. The exceptions
“This deemed disposition rule does not apply to every trust - the most common ones being a specified trust, which includes registered plans like RRSPs and RIFFS. There’s also an exception for unit trusts – like a mutual fund trust. With alter ego trusts, the tax is in the settlor’s hand and when they pass away, that’s when you have the first deemed disposition and then if the trust continues on, the next deemed disposition is 21 years after that.”
2. Distribution of capital
“If the trust document allows a distribution of capital to the beneficiaries, then the trustee can, before the 21 years is up, decide to distribute the property with that increase in value; that accrued gains. They can distribute that property to a capital beneficiary so if that is done, then the trust no longer owns the property and is not going to report any capital gains because the property is now owned by the beneficiaries. The tax liability on the capital gains will be transferred to the beneficiary and they won’t have to pay that tax, of course, until they pass away or actually sell the property.”
3. Bite the bullet
“In some cases, they might decide the trust should hang on to the property, bite the bullet and pay the tax. Quite often, trusts are created to hold on to property on behalf of beneficiaries because the settlor of the trust does not want the property to go to them. For example, young beneficiaries who are not financially responsible or have a disability, mental health issue or addiction. The only thing is the trust needs to have cash to pay the tax – that can be difficult because maybe the assets are not liquid, maybe they can’t generate cash. They can file to pay the tax over 10 years but that is usually done if there is a huge amount of tax.”
4. Sell up
“The trust can sell the property before the 21-year rule, so they are still being taxed on the gains but at least they sold the property and received the proceeds. They will now actually have the cash to pay the tax on that capital gain.”
5. Wind it up
“The other option is to wind up the trust. You always have to go back to the trust document to see the instructions. If the document says, at the 21-year rule, you need to distribute all the property to the beneficiaries sometime before the 21 years is up, then trustees have to carry that out. The document might say you have discretion – you can then decide to distribute it to avoid the tax bill.”
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