Brian Quinlan / Canadian MoneySaver
This is the second 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
Paying the deceased’s tax liability
The first article in this series dealt with the “deemed disposition” of assets on death. On death, a taxpayer is considered to have sold all his or her assets. The accrued capital gains — and perhaps recapture if rental real estate is owned — are triggered and included in the deceased’s income. At death, any RRSPs and RRIFs are deregistered and the value is also included in the deceased’s income. Finally, the deceased’s regular income earned in the year of death (employment, self-employment, pension and investment) is included in income for the year of death.
It is easy to see that the deceased may have a substantial taxable income in the year of death and a significant tax liability. When there is a surviving spouse (which for tax purposes includes a common-law spouse), the tax can be deferred where assets, RRSPs and RRIFs are passed to the spouse. However, where there is no surviving spouse, the tax is generally due by April 30 of the year following the death or six months after death — whichever is later.
This can be particularly onerous. The estate may have to sell the deceased’s assets to pay the income tax bill. Some assets cannot be liquidated immediately — such as rental real estate or family-use real estate like a cottage. Furthermore, the timing may not be appropriate if there is a depressed market.
With respect to the income tax for the deemed disposition of assets, the executor can elect to pay this tax in ten equal annual consecutive instalments, with the first payment made when the full tax payment would have been due. Canada Revenue Agency (CRA) will charge interest on the outstanding tax debt. The executor must make this election using form T2075 and must provide security to CRA.
Revisiting deemed dispositions
As noted, where assets are passed to a surviving spouse, the deceased does not incur a tax liability for any accrued capital gain or recapture at the time of death. This is an automatic tax provision — the tax bill for an appreciated asset is deferred until the surviving spouse sells the asset or dies owning the asset. Here’s how it works: the deceased spouse is deemed to have sold the asset to the surviving spouse at a selling price equal to the adjusted cost base (tax cost) of the asset. Therefore, no capital gain or recapture is recognized on the death of the first spouse.
However, there are instances where it’s best to avoid the automatic tax provision:
The deceased has realized capital losses in the year of death or in previous years. These losses cannot be passed to a surviving spouse — or any beneficiary. In this case, the best option would be to “elect out” of the automatic provision that allows an accrued capital gain to be realized. Here, the surviving spouse’s tax cost of the asset would be equal to the market value of the asset on the date of death. In other words, by making use of the deceased’s capital losses, the surviving spouse ensures that the tax cost of the asset “bumps up” (or increases) to market value at the time of death.
The deceased owns shares in a small business or farm/fishing property that qualifies for the capital gains exemption. If the deceased’s exemption is not used at the time of death, it is lost. Therefore, it is best to trigger the gain, make use of the exemption and give the surviving spouse a higher tax cost for the small business shares or farm/fishing property received. (The exemption amount for shares in a small business is $813,600 for 2015. On April 21, 2015, the exemption amount for a farm/fishing property became $1,000,000.)
The deceased has an alternative minimum tax carryforward amount. In this case, the best plan would be to have the deceased’s taxable income high enough to create an income tax liability that could be offset by the carryforward amount.
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 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 time of death and the tax cost is $1,000.