Here is everything you need to know about 21-year rule trust—including ways to negotiate them
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 applies to most personal trusts. It means that a deemed disposition comes into play and the trustee must file a return on all the property held as if he or she had sold it at fair market value. This also 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. That can prove problematic, especially if the cash is not readily available.
21-year rule trust: 5 key approaches
There are options, however. Jonathan Braun, manager, tax and estate planning at Investors Group, looks at how clients can negotiate the 21-year rule. Here is a quick look at five key approaches to the 21-year rule trust:
- The exceptions
- Distribution of capital
- Bite the bullet
- Sell up
- Wind it up
Now, let’s take a closer look at each.
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 RRIFs. 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. If that is done, then the trust no longer owns the property. It 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.”
What happens to a trust after 21 years?
After 21 years, a trust is generally deemed to have disposed of its entire capital property and land inventory. This is the case every 21 years, thereafter, for proceeds equal to its fair market value. And it also applies to the same property immediately for an amount equal to that fair market value. This means that trusts could be required to pay tax on capital gains, without getting the proceeds of disposition.
21-year-rule trusts were designed to prevent a trust from holding property for an indefinite period. This defers the taxation of capital from one generation to the next.
Why is it 21 years for trust?
The 21-year deemed disposition date applies to most trusts. These include family trusts and testamentary trusts that are created for beneficiaries, outside of common-law partners or spouses.
There are, however, other types of trusts where the first deemed disposition doesn’t happen 21 years after the trust was created. This includes a self-benefit trust or an alter ego trust, which are deemed to dispose of its capital property when the taxpayer dies. It also includes a joint-partner trust or a spousal trust, which are first deemed to have disposed of its capital property when the second spouse dies.
21 year rule trust: common misconception
A common misconception with the 21-year rule income tax act is that the trust must be wound up within 21 years. This is untrue. The 21-year rule simply deems a trust to have disposed of each property for proceeds equal to the fair market value on the deemed realization date. Additionally, the property must be reacquired immediately after.
There are situations where it might make more sense to have the trust recognize gains on the property—then to pay the tax. One instance of this is when the trust holds an investment portfolio that is traded frequently. In this case, the accrued gain might be nominal. This means that triggering the gain won’t mean significant tax.
Another example is if the trust holds private company shares. The share rights, as well as the restrictions, ought to be reviewed. This review can better determine the value of the shares that the trust holds. Let’s say the trust shares are entitled to dividends, for instance, but have no right to share in the growth of the company. In that case, the accrued gain could be nominal.
21-year rule trust: closing thoughts
Let’s review. The 21-year rule applies to most personal trusts. It means that a deemed disposition comes into play and the trustee must file a return on all the property held as if he or she had sold it at fair market value. This also means you are triggering, and taxed on, all the capital gains accrued over that time. When it comes to negotiating the 21-year rule, there are options.
It is therefore critical that you understand the basics of the 21-year rule trust, as well as the key approaches you can take, as outlined by our expert, Jonathan Braun. It is also important to understand the risks.
What is your experience with the 21-year rule trust? Did you find this guide useful? Let us know in the comment section below
