When people hear the expression “21-year rule,” they often associate it with family trusts and estate freezes. It is sometimes assumed that a trust created under a Will, commonly called a testamentary trust, is different and therefore escapes the rule.
That assumption can be wrong.
The Canadian Income Tax Act contains a general 21-year deemed-disposition rule that can apply to testamentary trusts. The rule can have significant consequences where a trust continues to hold appreciated real estate, investments, shares of a corporation or other capital property for an extended period.
What is the 21-year rule?
The 21-year rule is found principally in subsection 104(4) of the Income Tax Act.
Generally, a trust subject to the rule is deemed to have disposed of certain capital property at its fair market value on the applicable deemed-disposition date and to have immediately reacquired the property at that value.
The purpose of the rule is to prevent trusts from indefinitely deferring the recognition of capital gains. Without such a rule, a trust could potentially hold appreciating assets for generations without the gains ever being realized for income-tax purposes.
For an ordinary trust, the deemed disposition will generally occur 21 years after the trust was created, and subsequent deemed dispositions can occur every 21 years.
What about a testamentary trust?
A testamentary trust is a trust established as a consequence of an individual’s death, commonly under the terms of a Will.
The fact that the trust is testamentary does not automatically remove it from the 21-year rule.
For example, assume a person dies and leaves $2 million of investments in a trust for the benefit of a child. The Will provides that the trustees are to retain the investments and distribute income to the child for life, with the capital eventually passing to the grandchildren.
If the trust remains in existence and holds investments that have increased substantially in value, the trustees must consider the 21-year deemed-disposition rules.
The issue is therefore not simply:
“Was the trust created by a Will?”
The more important question is:
- “What type of trust was created, and what rules apply to that particular trust?”
The important exception: a testamentary spousal trust
One of the most important exceptions involves a testamentary spousal or common-law partner trust.
A properly structured spousal trust can qualify for special treatment under subsection 70(6). Generally, the surviving spouse must be entitled to receive all of the trust’s income during the spouse’s lifetime, and no person other than the spouse can receive or use the trust’s income or capital during that lifetime.
The 21-year rule does not operate in the ordinary manner for such a trust.
Instead, the relevant deemed disposition generally occurs on the death of the surviving spouse. At that time, the trust can be deemed to dispose of its capital property at fair market value.
This is a very important distinction.
A testamentary spousal trust may therefore provide a mechanism for deferring the realization of capital gains during the surviving spouse’s lifetime, but it does not necessarily eliminate the eventual tax.
An Example
Consider the following situation.
John dies in 2026. His Will creates a testamentary spousal trust for his wife, Mary.
The trust receives an investment portfolio worth $2 million. Mary is entitled to all of the income from the trust during her lifetime, and the trust is properly structured to qualify as a testamentary spousal trust.
The investments subsequently increase in value to $4 million.
The trust does not simply face a deemed disposition in 2047 merely because 21 years have passed since John’s death.
Instead, the special rules applicable to the spousal trust generally cause the deemed disposition to occur when Mary dies.
At that point, the $2 million increase in value could potentially give rise to a substantial capital gain.
The precise tax result will depend upon the assets, the adjusted cost base, the terms of the trust and the circumstances existing at that time.
What happens after the spouse dies?
This is where estate planning becomes particularly important.
A testamentary spousal trust may provide that, following the spouse’s death, the remaining property passes to children or grandchildren, either directly or through another trust.
The creation of a successor trust does not necessarily restart the 21-year clock.
The Income Tax Act contains specific rules, including subsection 104(5.8), designed to prevent taxpayers from simply transferring trust property from one trust to another to indefinitely postpone the 21-year deemed disposition. CRA has specifically addressed situations involving a testamentary spousal trust and a successor trust.
Consequently, careful planning is required when the surviving spouse dies and the trust property is moved into another trust.
The practical estate-planning issue
The 21-year rule is particularly important where a testamentary trust owns assets that are expected to appreciate significantly.
These could include:
- investment portfolios;
- shares of a private corporation;
- rental properties;
- commercial real estate;
- cottages or other recreational properties; and
- other capital assets with substantial accrued gains.
If the trust simply continues to hold those assets, the trustees cannot assume that the tax consequences can be deferred indefinitely.
The trustees and beneficiaries should know when the applicable deemed-disposition date occurs and what planning opportunities may exist before that date.
In appropriate circumstances, property may be distributed to beneficiaries before the deemed-disposition date on a tax-deferred basis under applicable provisions of the Income Tax Act. CRA specifically recognizes that subsection 107(2) may, in appropriate circumstances, allow trust property to be distributed to capital beneficiaries without immediately triggering the 21-year realization.
That does not mean that every distribution is tax-free. The terms of the trust, the identity of the beneficiary and the nature of the property all matter.
The Distinctions
It is useful to distinguish three situations:
| Trust | General treatment |
| Ordinary testamentary trust | Generally subject to the 21-year deemed-disposition rule |
| Testamentary spousal/common-law partner trust | Special rules generally defer the deemed disposition until the death of the surviving spouse/partner |
| Successor trust following a testamentary trust | Special rules may prevent the 21-year period from simply starting over |
The legislation is considerably more complicated than this table suggests, but it illustrates the fundamental point.
Don’t confuse probate with the 21-year rule
The 21-year rule is also entirely separate from probate.
Probate deals primarily with the authority of an estate trustee to deal with assets passing through the estate and the applicable estate administration tax.
The 21-year rule is an income-tax rule concerning trusts and deemed dispositions of property.
The two concepts should not be confused when advising clients about estate planning.
Planning in advance
The biggest mistake may be waiting until the 21st anniversary to consider the issue.
By that point, a trust may own property that has appreciated substantially. The resulting deemed disposition could create a significant tax liability, even though the trust has not actually sold the property.
For that reason, trustees should maintain a record of:
- the date the trust was created;
- the type of trust;
- the terms of the Will and trust;
- the adjusted cost base of significant assets;
- the current fair market value of those assets;
- the applicable deemed-disposition date; and
- the potential tax consequences of retaining or distributing the assets.
Conclusion
The 21-year rule can apply to testamentary trusts.
The important qualification is that not all testamentary trusts are treated in exactly the same way.
A properly structured testamentary spousal trust has special rules, with the relevant deemed disposition generally occurring on the death of the surviving spouse rather than simply 21 years after the original death. Other testamentary trusts can be subject to the ordinary 21-year regime.
For families using testamentary trusts as part of their estate plan, the trust should therefore be reviewed not only when it is created, but also as assets appreciate and as the relevant deemed-disposition date approaches.
The objective is not necessarily to avoid the tax entirely. Rather, proper planning can help determine when the tax will arise, who will bear it, and whether the trust’s assets should be distributed or reorganized before the deemed disposition occurs.
This article is intended as general information concerning Canadian tax and estate planning principles. The application of the Income Tax Act depends upon the particular terms of the Will, trust, assets and beneficiaries. Professional tax and legal advice should be obtained before implementing any estate-planning strategy.
Brian Madigan LL.B., Broker
www.OntarioRealEstateSource.com