Brian Quinlan / Canadian MoneySaver
Based on the original article prepared for Canadian MoneySaver Magazine. This is the first article in a series of four presenting the income tax implications of the death of a taxpayer.
Part 1: The tax implications of death
Part 2: Specific rules that can impact the filing of final personal tax returns
Part 3: Mandatory and optional tax returns for a deceased taxpayer
Part 4: Strategies to adopt while alive to minimize the income tax due on death
Implications of the death of a taxpayer
At death, a taxpayer may
- own marketable securities (shares of public companies, mutual funds, etc.) directly
- own marketable securities through an RRSP, an RRIF or a TFSA
- own real estate, such as rental properties and family-use properties (home, cottage)
- own personal-use property such as a car, a boat, art and jewelry
On death, a taxpayer is considered to have sold all their assets at a price equal to the market value at the time. In other words, the deceased has a “deemed disposition” of all their assets. Fifty per cent of the resulting net capital gains (capital gains in excess of permitted capital losses) is taxable in the final personal tax return of the deceased.
When the deceased has an RRSP or an RRIF, these plans are de-registered on death resulting in 100% of the value at the time of death being taxable — again, on the deceased’s final income tax return. Assets held in a TFSA at the time of death remain tax-free to the deceased.
An important exception to the above tax rules is when assets, RRSPs and RRIFs are passed on death to a spouse (which for tax includes a common-law partner). When this is the case, no income tax will arise on the death of the first spouse. The surviving spouse will only have a tax liability in two instances:
- when there is a future taxable event, such as a sale of an inherited asset or a withdrawal from an RRSP or an RRIF received from the deceased spouse on the surviving spouse’s death.
With respect to a TFSA, the surviving spouse will not be subject to income tax on the income earned after the first spouse’s death if he or she was named as a “successor holder.”
Investments in marketable securities
As with an actual sale of a marketable security — not held within an RRSP, an RRIF or a TFSA — it is important to ensure the capital gain (or capital loss) is calculated correctly in reporting the deemed disposition. Obtaining the value of a publicly traded security at the time of death is not difficult. Therefore, the focus is on ensuring the tax cost (the adjusted cost base) of the security is not understated. Common errors in calculating the tax cost of a security fall into four categories:
- omitting the increase in the tax cost where the deceased taxpayer made the February 22, 1994, capital gains election as the $100,000 capital gains exemption ended
- ignoring non-cash mutual fund allocations of income, which serve to increase the tax cost of mutual fund units
- not correctly taking into account stock splits and corporate “spin-offs”
- forgetting to include acquisition commissions in the tax cost
With respect to the “deemed disposition” of rental properties held at death, a capital gain can be triggered on the land and building portions of the property. If the value at death is below the tax cost, then a capital loss may be claimed on the land portion. However, a capital loss on a depreciable asset — such as a building — is not permitted so a capital loss is not permitted for the building portion of a rental property.
In addition to the potential for a capital gain, the deceased is exposed to recapture of past tax deductions of capital cost allowance (CCA or tax depreciation) claimed on the building portion. Recapture, or tax depreciation reversal, will occur when the value of the building on death is equal to or greater than the tax cost of the building. In this case, the tax rules imply that since there has been no economic loss on the building, the depreciation claims were not warranted. As the past depreciation/CCA claims were 100% tax deductible, the recapture of these claims is 100% taxable.
If the building portion has decreased to a value that is below the depreciated value for tax purposes (the undepreciated capital cost or UCC), then a terminal loss may be claimed. This is “negative recapture” and is 100% tax deductible. A terminal loss takes the “tax sting” out of not being permitted to claim a capital loss on the building portion of the rental portion.
With respect to family-use properties — such as a home and a cottage — the deceased can make use of the principal residence exemption to shelter all or a portion of the accrued capital gains on these properties. Where there is more than one property, it is necessary to decide on how best to use the principal residence exemption. This decision will be based on the amount of the accrued gain on each property at the time of death, the number of years each property was owned and the past use of the exemption by the deceased and the deceased’s spouse. Generally, it is best to make use of the principal residence exemption in respect of the property that has the “highest accrued capital gain per year owned.” If there is an accrued loss on family-use real estate, the deceased’s estate cannot claim a capital loss.
In determining the tax cost of family-use real estate that has been held for a long time, the beginning point is the value of the property on January 1, 1972. (No income tax on capital gains is accrued before 1972.) The tax cost is then increased by improvements made to the property. Also, many taxpayers made use of the February 22, 1994, capital gains election to increase the tax cost of their cottages.
Avoiding tax on RRSPs and RRIFs at death
The deceased will not be subject to tax on the value of his or her RRSP or RRIF on death if the RRSP or RRIF proceeds are
- transferred to a financially dependent child or grandchild or
- transferred to a Registered Disability Savings Plan (RDSP) of a financially dependent child or grandchild
When the beneficiary of an RRSP or an RRIF is a financially dependent child or grandchild of the deceased, the value of the RRSP or RRIF is taxed in the hands of the dependant rather than the deceased. If the child or grandchild is under 18, the tax can be spread over the number of years remaining until the child is 18 with the purchase of an annuity.
Should the financial dependency have been due to a physical or mental disability, the dependent can avoid being immediately taxed on the RRSP or RRIF proceeds in one of two ways:
- by making a transfer to his or her own RRSP or RRIF or
- by using the funds to purchase an annuity
Tax is then paid by the dependent only as withdrawals are made from the RRSP or RRIF or when an annuity payment is received.
A deceased taxpayer can avoid tax on the value of an RRSP or an RRIF at death by having the proceeds transferred to an RDSP of a financially dependent child or grandchild. The amount transferred to the RDSP cannot cause the beneficiary’s maximum RDSP contribution room to exceed $200,000 and no Canada Disability Savings Grant is paid on the transfer. The beneficiary will pay tax as amounts are taken out of the RDSP.
For the child or grandchild to be considered financially dependent, his or her income for the previous year cannot exceed the basic personal tax credit amount of $11,327 (2015). If the child or grandchild is disabled, that amount is $19,226 (2015). This is the total of the basic personal tax credit and the disability tax credit. The Income Tax Act states that these amounts are to be used “unless the contrary is established.”
Tax-Free Savings Account
On death, the TFSA retains its “tax-free” status. No tax is payable by the deceased. If the surviving spouse is named the “successor holder” of the TFSA, the funds can be transferred to the surviving spouse without affecting the spouse’s TFSA contribution room. The TFSA of the deceased continues to exist and the income earned in the TFSA after the date of death is not taxable to the surviving spouse.
When the spouse is not named as a successor holder but is named a beneficiary, he or she may still receive the deceased’s TFSA funds tax-free. He or she may also contribute those to their own TFSA without affecting their TFSA contribution room. This is referred to as an “exempt contribution.” The maximum the spouse can receive tax-free and the maximum exempt contribution that may be made is limited to the value of the deceased’s TFSA at the time of death. Any income earned in the deceased’s TFSA after death is taxable to the surviving spouse.
Beneficiaries other than a spouse — such as a child — cannot make an exempt contribution. Of course, a beneficiary can contribute any funds received to their own TFSA provided they have unused TFSA contribution room. The amount received by the non-spouse beneficiary is not subject to tax to the extent it does not exceed the value of the TFSA at the time of the deceased’s death.
Any taxable capital gains that result from the deemed dispositions of personal-use property — such as cars and boats — are subject to tax on death. If there are accrued losses on assets such as these, the capital losses cannot be claimed. A capital loss on one personal-use asset cannot be used to offset a capital gain on another personal-use asset.
An exception to the above deals with personal-use property that is “listed personal property” — art, jewelry, rare books, stamps and coins. In respect of the deemed disposition rules on death, capital losses are permitted to be claimed on listed personal property assets but only to the extent they offset any capital gains on listed personal property.
The minimum value to use in calculating the gains and losses on personal-use property for both the deemed market value at the time of death and the tax cost is $1,000.