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tax matters

Finally, it feels as though spring has arrived. This means two things around our home: It's time to pull out the golf clubs and time to open the summer home. The worms at the course where I play are pretty crafty. When they see me coming they hide under my ball; it's the only safe place for them. So I promise not to give any golfing advice today. As for vacation properties, though, I'd like to talk about a common ownership structure: the family trust.

The trust
A trust can be a useful estate planning tool for vacation property owners. Basically, a trust is a relationship among three parties: the settlor, trustee and beneficiary. The trust is created when the settlor transfers certain assets to one or more trustees, who hold and manage those assets for the benefit of the beneficiary (or beneficiaries). The beneficiaries enjoy the use of the assets but do not legally own them. If, for example, you transferred your cottage to your sister in trust for your children, your sister would legally own the property, but your children – not your sister – would be entitled to use the property.

A trust set up during the lifetime of the settlor is called an "inter vivos" trust, while a trust set up upon the death of the settlor through his or her will is a "testamentary" trust. Currently, inter vivos trusts are taxed at the highest marginal tax rate while testamentary trusts are subject to graduated rates of tax, like individuals (although the March 21 federal budget announced the government is considering a change that could see testamentary trusts taxed at higher rates).

The benefits
Holding your family cottage in a trust can provide some benefits, including: protection from creditors (assets held in certain trusts can be difficult for creditors to reach), proper governance (in cases where multiple individuals share a cottage, having one or more trustees manage the property can minimize disputes), tax minimization (the future growth of the cottage's value will not accrue in the settlor's hands, which can reduce or defer taxes), maintaining control (the settlor can be named one of the trustees, who manage the property), and minimizing probate fees.

The nuances
In deciding whether to set up a trust to hold your cottage, there are a few issues to consider:

• There is a deemed disposition every 21 years. On the 21st anniversary of the trust there will be a deemed disposition of its assets, which could trigger taxable capital gains at that time. There are ways to deal with this potential tax hit, including distribution of the trust to beneficiaries before that date, or the trust's use of the principal residence exemption (PRE) on the property, among other ideas. A tax pro should be consulted to plan for this.

• The principal residence exemption becomes finicky. A trust can use the PRE to shelter a sale of the cottage from tax as long as one or more of the beneficiaries stay at the cottage regularly. But it may make more sense to distribute the cottage to a beneficiary before the property is sold. If the trust designates the cottage as a principal residence for a given year then, generally, none of the beneficiaries will be able to also designate their own homes as a principal residence for the same time period. I've simplified things here, so speak to a tax pro for more details.

• Transferring assets to a trust can be a taxable event. In the case of a vacation property, it simplifies things if you set up a trust to acquire it from the outset. If you already own the cottage and it has appreciated in value, transferring it to a trust can trigger a taxable capital gain. It may be possible to shelter this gain with the PRE, but whether this is possible, or sensible, will depend on what other properties you own, how those have appreciated in value, and what plans you have for those other properties in the future.

• You must have a properly drafted trust agreement. In order for a valid trust to exist, certain conditions must be met. A written trust agreement will generally ensure a trust is valid. This will cost a little money, but is an important part of the process.

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.