Trusts as real estate owners21 years: an anniversary not to celebrate
Sarah Benammar, CPA, CGA, LL. M. Fisc., Senior Manager
Many Canadian and foreign investors were advised to set up domestic or foreign trusts to acquire investment real estate properties in Canada in the early 2000’s, late 90’s and way before.
Amongst other motives, trusts used to be an attractive vehicle to hold real estate property from an income tax perspective, as trusts were not subject to provincial tax on capital and, in the context of foreign trusts, were not subject to limitations on the deductions on certain interest expenses. Today, trusts are still used to acquire real estate properties in a family setting, whether it is for an asset protection purpose or for estate and family law planning objectives.
Those trusts which were created in the late 90’s and the early 2000’s are now forced to consider a pending tax consequence which, in some cases, were not considered when the trusts were settled and used to acquire real estate property. Commonly referred to as the “21-Year Rule”, trusts are, for income tax purposes, generally subject to a deemed disposition at fair market value of all their assets upon the 21st anniversary of their initial settlement and every 21 years thereafter. This rule applies to most trusts resident in Canada, or alternatively, foreign trusts taxable in Canada, and is primarily intended to prevent an indefinite deferral of income taxes associated with the increase in value of the trust’s assets. Depending on the cost of acquisition of the trust’s assets and their fair market value at the time of the trust’s 21st anniversary, a capital gain may result in a significant income tax liability, with no sale proceeds cash realization to fund significant income taxes payable if the deemed disposition is allowed to occur. Considering the long term ownership period appreciation driven by increased rent revenues and current capitalization rate compression, the income tax liability may be significant and may obligate investors to make unwanted decisions with respect to the ownership of their assets to pay for the income taxes resulting from the 21-Year Rule.
Take for example a Canadian-resident trust that was settled on November 1, 1998. Soon after being settled, the trustees organize to acquire a commercial real estate property in the province of Québec for $10 Million. In this example, the use of the trust was partially tax-motivated, as the trust would not have been subject to the Tax on Capital imposed by the provincial government at that time.
Twenty-one years later, the trust’s sole asset, being the commercial real estate property, is now worth $30 Million. Assuming no planning is done to mitigate the 21-Year Rule, the trust will be deemed, on November 1, 2019, to have disposed of its property for its fair market value of $30 Million and to have reacquired it at the same amount. This deemed disposition will trigger a capital gain of $20 Million, which will be subject to a 27% income tax rate on a federal and provincial combined basis, resulting in an income tax liability of approximately $5.4 Million. With insufficient liquidity to pay off this liability, the 21-Year Rule can be an unwelcomed surprise.
Consideration may be given to some planning in advance of the 21-Year Rule applying. Any planning starts with a review by your tax advisor of the rights and obligations of the trustees toward the beneficiaries of the trust.
Distribution of the property
Generally, a trust can transfer its properties to one or more capital beneficiaries on a tax-free basis, even if the properties have increased in value while the trust owned the property. The properties with accrued gains will then be held by the beneficiaries directly and the gains will be taxable when the properties are sold by the beneficiaries or deemed to be sold on death in the case of an individual beneficiary.
Although this option may sound simple, it may not be the desired solution. As a potential obstacle, any transfer of a real estate from a trust to a beneficiary may trigger land transfer tax, as the anti-nominee deferral rules are now applicable. However, a distribution of the property from a trust to a corporate beneficiary as opposed to an individual beneficiary may result in an income tax savings on the annual rental income, as corporations can be taxed at a rate of approximately 27% for certain cases involving non-residents, rather than the 53% tax rate applicable to individuals and trusts. When considering this option in a real estate context, a cost-benefit analysis considering the annual income tax savings and the one-time cost associated with the land transfer tax would be required.
Whether it is for creditor protection or privacy reasons, certain owners may be reluctant to having individual beneficiaries holding the property directly in situations where a trust deed provides for distributions to individuals only. As such, for distributions of properties from the trust, itis important to ensure that the trust deed is flexible to allow for the transfer of assets to a corporate beneficiary since some trust documents do not allow for adjustments when it comes to capital distributions. If the trust deed does not provide for such flexibility, an amendment to the trust deed may be an option although this may require a tax consequence analysis and the intervention of the courts.
As well, certain type of trusts, commonly-referred to as “reversionary trusts”, are precluded from benefiting from the tax-free distribution to their beneficiaries. In a nutshell, the reversionary trust rules apply when property of the trust may revert to the settlor or contributor or if the settlor or the contributor has control over the distributions. A thorough review of the trust agreement and trust history is therefore essential when deciding on the strategy to deal with the 21-Year Rule.
One of the exceptions to the 21-Year Rule is when all interests in properties under the control of the trustee have vested indefeasibly and not more than 20% of the trust’s beneficiaries are non-residents of Canada. A beneficiary’s interest in a trust is considered to have vested indefeasibly when the beneficiary has the absolute and unconditional ownership of its interest that cannot be defeated by any past or future event. In other words, the interests are considered to have vested indefeasibly when each beneficiary’s interest is fixed and the trustee has no discretion to alter the interests. A careful review of the trusts deed is required to determine whether a trustee is allowed to take this action.
In the event that the trust deed does not allow for this exception, it may be possible to amend the trust deed by way of legal resolutions to have the trust’s interests vest indefeasibly. However, there is a risk that such amendment could result in a variation of the trust for tax purposes, which could trigger a deemed disposition at fair market value of the trust’s assets. In addition, even though the beneficiary does not own the underlying trust property, the vested trust interest is a fixed and determinable interest in property and will therefore become an asset that is fully exposed to creditors of the vested beneficiary. As such, obtaining advice from professionals is highly recommended prior to the implementation of this strategy.
Trigger the 21-Year Rule
There is a common misconception that all trusts facing the 21-Year Rule need to plan in order to avoid its application. In fact, there are several situations where it makes sense to simply have the trust recognize the deemed disposition and pay the income tax, if any.
For example, in situations where a big anchor tenant is lost resulting in a decrease in value of the property, the application of the 21-Year Rule will not create an income tax liability as the deemed disposition would result in a capital loss and any planning to avoid the 21-Year Rule may not be necessary. In this case, the trust would simply continue to own the property without any tax consequences until such time as the property is sold or until the application of a subsequent 21-Year Rule. In these circumstances, it is highly recommended that a valuation report is obtained from a real estate appraiser to support the decrease in value, as the tax authorities will likely challenge the fair market value used for purposes of applying the 21-Year Rule.
In a family context, a trust may have been initially created to hold assets on behalf of one or more individual beneficiaries having mental health issues, who are financially irresponsible or who are at risk of a legal liability or claim. In these circumstances, it may be advisable to trigger the application of 21-Year Rule, where the trust would pay the income taxes and continue to hold the property.
If the tax is to be paid by the trust, it is important to ensure that it has sufficient liquidity to do so, otherwise, an election is available allowing the trust to pay the applicable taxes in 10 equal annual payments. However, security must be provided to the tax authorities and interest is payable on the deferred taxes owing.
Planning for the deemed disposition rules is complex, and the options suggested above may not be appropriate for all trusts. An analysis of the various options may take time to address and it is often both appropriate and necessary to consider the implications of this 21-Year Rule several years in advance. For these reasons, it is strongly advisable that the trustees seek professional advice from their tax advisor prior to making any decisions.