Article written by Caroline Poulin, LL. M
Unlike other jurisdictions, Canada and Quebec do not personally tax individuals who inherit property. In fact, under our tax system, the tax is applied to the individual’s income tax return upon death, and to the estate’s tax return thereafter. As a result, it’s often best to plan ahead for potential tax issues. Here’s a non-exhaustive overview of the important elements to consider.
Deceased person’s tax
For tax purposes, an individual is deemed to have disposed of all capital assets at fair market value immediately prior to death. In this case, the capital gain accumulated on each property will be taxed on the deceased’s final tax return, generating a capital gain taxable at 50%. The deceased will also be considered to have cashed in his or her RRSP or RRIF in full, and the balance of the plan will be added to current income. These items will therefore be added to the income earned by the deceased between January 1 and the date of death.
The tax resulting from the deemed disposition of the deceased’s assets can represent a significant amount. The amount of tax payable will have to be paid by the liquidator from the estate’s assets, which can significantly reduce the value of the assets that will be distributed to the heirs.
Income tax returns
If certain assets held by the estate generate income between the date of death and the date of distribution (e.g. rental property, investment portfolio, etc.), this income will be taxed directly on the estate’s tax return. The estate, for its part, must file an income tax return every year until its final settlement.
Spousal rollover on death
However, certain tax strategies can reduce the amount of tax payable on the deceased’s final tax return. For example, an individual may wish to make bequests during his or her lifetime. This planning allows individuals to better manage the tax consequences of disposing of their assets by controlling the timing of the disposition, and therefore the applicable tax rate, in addition to contributing during their lifetime to the financial health of their loved ones. At the time of death, the bequest of certain assets to a spouse or a testamentary spousal trust allows certain assets to be transferred tax-free at the time of death through a “tax rollover”.
Special mechanisms can also be put in place to reduce death taxes when an individual holds shares in a Canadian-controlled private corporation. But we need to act upstream. For a shareholder, a significant capital gain may have been accumulated on the shares held. This unrealized capital gain can lead to substantial death taxes and a liquidity issue.
As far as liquidity is concerned, this can be a major issue for the company, which has an obligation to redeem the deceased’s shares, or for the liquidator, who has to pay the taxes due on the individual’s death. Taking out life insurance can be a useful solution for this type of issue, as the insurance proceeds are generally tax-free.
Fiduciary or estate freeze
With regard to unrealized capital gains on shares and the resulting tax consequences, various plans, such as setting up a fiduciary freeze or an estate freeze, can reduce the capital gain taxable on an individual’s death.
It is also important to verify whether the shares held by an individual qualify as eligible shares so that the individual can use his or her capital gains deduction (“CGD”) against the gain arising from the deemed disposition of the shares at death. For 2022, the total amount of DGC is $913,630, which is indexed to $971,190 for 2023.
Tax planning can be very important in minimizing the taxes arising from an individual’s death and maximizing the value of the assets passed on to the estate.
Don’t hesitate to contact a member of our tax team to discuss your options further and assess the full range of potential tax consequences.
