Although neither Canada nor Quebec impose estate tax or succession duties, there are, unfortunately, income tax consequences upon death. In our federal and provincial tax systems, the general concept is to treat your date of death as a time when you – the deceased – notionally dispose of all your assets at fair market value, giving rise to income and/or capital gains. However, as with most rules, there are some exceptions.
To the extent that income and capital gains are deemed to be realized at death, these amounts will be reported in what is known as the “terminal tax return” for the year of death, covering the period of January 1 of your year of death, up to and including your date of death. In addition to the ordinary terminal return, there may be opportunities to file separate returns in your year of death for business or partnership or certain trust income, as well as for a specific class of entitlements termed “rights and things.” Filing a separate return in these cases will normally give rise to tax savings because each return can claim certain personal tax credits and use its own graduated tax rate scale.
So, what are some common examples of the consequences of the deemed disposition rules, assuming no exception is available?
- The value of an RRSP or RRIF at the date of your death is considered income which must be reported in your terminal return, as if all the funds were withdrawn at death.
- 50% of the capital gains inherent in a portfolio of marketable securities are included in your terminal return, as if the portfolio was sold on your date of death.
- The embedded recapture and 50% of the capital gain must be reported for a rental property.
The most common exception to the requirement deeming a realization at fair market value at your date of death is when you have a surviving spouse. When those assets are inherited by your spouse, or by a spousal trust (where only your surviving spouse can receive any income from the trust, or if the terms of the trust allows capital), such assets are realized at the cost base to the deceased instead of the fair market value. The effect is that no income or capital gain would be reported in your terminal return. Instead, the taxation would be deferred to the actual sale of the asset or death of your surviving spouse, whichever is earlier. Note that it is possible to elect out of these deferral rules.
Now we can compare the results of benefitting from the spousal exception as opposed to the general deemed disposition rules. Your surviving spouse may inherit the RRSP paying no tax until the funds are withdrawn. Thus, the RRSP has the chance to continue to grow. Likewise, your surviving spouse or spousal trust may inherit a stock portfolio or the rental property paying tax on the gains that had accrued up to the first death only as the portfolio or property is sold, or upon his or her later death.
Unfortunately, in the case of a private corporation owned by you, the deceased, the disposition rules can result in double taxation when your heirs access the funds. There are certain recognized techniques to eliminate or reduce this difficulty. It is important to address the issue within one year of death, or certain opportunities will be lost.
It is worth noting that the capital gains exemption, presently $883,384, to the extent not previously utilized by you, the deceased, is still available to reduce the capital gain at death with respect to shares of qualifying small business (this figure rises to 1 million for certain farm or fishing property). Remember that 50% of the capital gain after deducting the available exemption would then be included in the terminal return.
Other exceptions may also apply to avoid the general disposition rule, for example in the case of financially dependent children or disabled heirs.
Now that you know a little bit more about the basics regarding taxation at death, what would you do to minimize the tax burden of your death on your heir? This area of our tax system is extremely complex, and it is important to consult a knowledgeable advisor to optimize your succession tax results.