The 2024 federal budget proposes a significant change that could impact life interest trusts: an increase in the capital gains inclusion rate from 50% to 66.67% for trusts on the first realized dollar and for individuals after a $250,000 threshold. This alteration, set to take effect on June 25, 2024, could lead to a scenario where capital gains are effectively trapped within the trust upon the death of the life interest beneficiary. Under the proposed rules, any accrued capital gains on trust assets would be taxed in the hands of the deceased beneficiary's final tax return, rather than being deferred until the trust assets are distributed to the remainder beneficiaries.
What is a Life Interest Trust?
A life interest is a valuable right granting one the enjoyment of a specified property for the rest of one’s life. For instance, transferring your home to your child while retaining the right to reside in it until your passing.
Life interest trusts are often used in estate planning to bypass probate, ensure privacy and confidentiality, act as a substitute for a will, and ensure ongoing benefit from assets while preserving family legacies. They allow you to grant a beneficiary, typically a surviving spouse or partner, the right to use or receive income from specific assets during their lifetime. Upon the beneficiary's death, the remaining assets (the "capital") are then distributed to the designated residual beneficiaries, often children or grandchildren.
This arrangement can be particularly useful in situations where you want to provide for your spouse while also ensuring that your children from a previous relationship ultimately inherit your assets. It can also help protect assets from being used for long-term care costs or being passed on to a new spouse in the event of remarriage.
There are three common types of life interest trusts – all subject to a deemed disposition when the beneficiary of the trust dies:
- Alter Ego Trust: The settlor (age 65 and over) establishes and contributes to the trust, and they are the sole life interest beneficiary during their lifetime.
- Joint Spousal or Common-Law Partner Trust: The settlor(s) (age 65 and over) and their spouse or partner are the only life interest beneficiaries.
- Spousal Trust: The spouse or partner of the individual who establishes and contributes to the trust (any age) is the only life interest beneficiary.
Strategies to Mitigate the Impact of a Higher Inclusion Rate
Subject to the provisions of the trust deed, clients can allocate gains to beneficiaries prior to their passing. Another approach involves the tax-efficient transfer of assets from the life interest trust during the beneficiary's lifetime, enabling the beneficiary to execute property sales. Both strategies leverage the 50% inclusion rate applicable to the initial $250,000 of annual gains, offering significant advantages.
Before transferring assets out of the trust, clients should evaluate whether any losses or loss carryforwards could offset the gains, potentially reducing the need for such transfers before death. However, it's crucial to prioritize the original intent of the trust and avoid solely focusing on immediate tax advantages. If the objective is to provide ongoing support to a spouse while safeguarding capital for residual beneficiaries, transferring assets out of a life interest trust might not be advisable.
In cases where the trust deed lacks explicit provisions regarding the inclusion of realized capital gains in annual income distributions, the ability to allocate a capital gain may be restricted. For contributions executed on or after June 25, clients have the option to forgo the tax-deferred rollover. Consequently, the gain on the property would be subject to taxation for the clients, while the trust would assume ownership of the asset at an augmented cost base. This strategy leverages the $250,000 threshold and personal capital losses to offset gains.
BOTTOM LINE
The impending increase in the capital gains inclusion rate for trusts poses challenges in estate planning. Without clarity on the tax treatment of gains realized before the deadline but distributed thereafter, it's crucial to proactively allocate gains or transfer assets before the effective date to avoid potential complications. Our team is actively exploring strategies to mitigate the impact of this rate hike. If you have any questions or would like to speak to a portfolio manager, please give us a call.