Changes made in 2016 to the Income Tax Act resulted in unfair treatment to disabled Canadians by restricting which types of trusts were eligible for a “principal residence exemption” (PRE). Now the Department of Finance has issued a letter of comfort, attempting to rectify these unfair changes.

What is the PRE?

In short, the PRE allows Canadians, when selling their principal residence, to avoid being taxed on their realized capital gains. Without this exemption, someone selling their principal residence would be taxed on 50% of their capital gains, which could be very significant when taking into account the value of the property.

Injustice with the Current Rules

The changes introduced in the Income Tax Act in 2016 meant only three categories of trusts could claim the exemption. The first was life interest trusts, the second was qualified disability trusts, and the third was inter vivos or testamentary trusts established for a minor child with one or more parents being deceased.

This definition significantly restricted the type of trusts that were eligible to claim the PRE. Because the second category, qualified disability trusts, are testamentary trusts  (resulting from death), this meant that disabled taxpayers who were the beneficiaries of inter vivos trusts (not resulting from death) could not claim the exception and would have capital gains on their principal residence taxed at the highest rate.

In practice, this would result in an unexpected and significant amount of income tax being due 21 years after the creation of the trust, because after 21 years the trust will have been deemed to have disposed of its capital property. If a disabled beneficiary did not have enough funds available in the trust to pay the capital gains tax, there could be severe consequences.

Proposed Improvements

In response to this problem, the Department of Finance has issued a comfort letter stating that it will make recommendations to the Minister of Finance to fix the issue. This would involve amending the Income Tax Act to permit certain inter vivos trusts to claim the PRE. This would also be subject to certain conditions. Firstly, the beneficiary needs to be a resident in Canada who is disabled (able to claim the disability tax credit). Secondly, the beneficiary must be a child, spouse, common-law partner, or former spouse or partner of the trust’s settlor. Thirdly and finally, no one other than the qualifying disabled beneficiary can receive the income or capital of the trust. If these three conditions are satisfied, the disabled beneficiary would be able to claim the tax exemption for their principal residence.

Fixing the injustice

This proposal was made recently and has not yet been implemented. Any laws that put disabled Canadians at a disadvantage, even inadvertently, ought to be changed and the injustice should be corrected. Implementation of these recommendations would be welcome and cannot arrive soon enough.

Thanks for reading,

Suzana Popovic-Montag & Sean Hess