We all know the old saying that there are only two sure things in life: death and taxes. While that may be true, it is also the case that one must typically pay taxes even after death (in which case the taxes will be paid out of your estate).
The Income Tax Act contains several rules that apply specifically upon the death of an individual. Some of the main rules are as follows.
Each capital property you own is deemed to be disposed of immediately before your death for fair market value proceeds, and the person acquiring the property (e.g. your heir under your will) is deemed to have a cost equal to that fair market value (FMV). As a result, most of your accrued capital gains and losses will be realized on your death.
Whether the deemed disposition results in a significant tax liability obviously depends on the amount of your accrued gains relative to losses at the time of death.
At the time of your death, you owned stocks with a cost of $200,000 and FMV of $700,000. You also owned mutual funds with a cost of $500,000 and FMV of $400,000.
The deemed disposition rules will generate a capital gain of $500,000 for the stocks, of which $250,000 will be included in your income (as a “taxable capital gain”) since capital gains are only half-taxed. The deemed disposition of the mutual funds will lead to a capital loss of $100,000, of which $50,000 will be an allowable capital loss. You will have income of $250,000 − $50,000, or $200,000, and will be required to pay tax on that amount (on your return for the year of death).
The person inheriting the stocks will have a cost of $700,000 and the person acquiring the mutual funds will have a cost of $400,000.
Whether the deemed disposition results in tax also depends on whether you leave the property to your spouse or common-law partner (or a qualified trust with the spouse or common-law partner as beneficiary). If you do, a tax-free “rollover” normally applies, under which the deemed disposition takes place at your cost, rather than FMV. In other words, there will be no gain or loss on your death.
Assume the facts as above except that the properties are left to your spouse. You will have a deemed disposition at the properties’ cost and your spouse will pick up the same cost. Thus, there is no gain or loss for you, and your spouse’s cost of the stocks will be $200,000 and their cost of the mutual funds will be $500,000.
However, your executor or legal representative can elect out of the rollover to your spouse, in which case the properties are deemed to be disposed of at FMV under the first rule above. For the stocks in the above example, it might make sense to trigger the capital gain if you have unused losses that could offset the capital gain, since this would bump up the cost of the property for your spouse. Also, if the stocks were in “qualified small business corporations” or “family farm or fishing corporations”, the resulting gain could be eligible for the lifetime capital gains exemption, assuming you have some of that exemption remaining. If so, you would pay little or no tax, and again your spouse would have a bumped-up cost of the stocks.
For the mutual funds in the above example, it might make sense for your executor to elect out of the rollover because the FMV deemed disposition would result in a capital loss, which you might be able to use in your final tax return as discussed below.
If you are liable for tax as a result of the deemed disposition rules, your executor can elect to pay the tax in instalments, with interest, over a period of up to 10 years.
Using capital losses
One-half of capital losses are allowable capital losses, and they can normally only reduce taxable capital gains and not other forms of income.
However, when you die, this rule is relaxed and replaced by a special rule. If you have allowable capital losses remaining after using them against your taxable capital gains, the special rule says that remaining allowable capital losses can be used to reduce your other sources of income such as employment income, and business and property income. (However, the reduction of other sources of income under the special rule may be limited if you have ever claimed the capital gains exemption.)
Where the special rules apply, you can reduce the other sources of income for the year of your death or in the immediately preceding year. If you had already filed the preceding year’s return, your executor can file a form to amend it.
Accrued wages and similar amounts
If certain amounts of income have accrued to time of your death, and you did not receive them prior to your death, they will be included in your income for the year of death. This will include items such as accrued interest, wages, and other amounts payable periodically that you did not receive before your death.
You are employed and receive a monthly wage of $10,000, payable at the end of the month. You die half-way through a month. The $5,000 wages accrued to the time of your death will be included in your income in the year of death.
“Rights and things” at death
If you have “rights or things” at the time of death, their value will be included in your income. In general terms, these are rights to amounts that you had at the time of death, which were not otherwise included in your income because the rights were not realized or disposed of. A common example is unpaid wages from a previous pay period. Another example is a declared dividend on shares you own, which were declared before your death but not paid until after your death.
You are paid a monthly $10,000 salary at the end of each month. You die in March but have not yet received the salary for February. The $10,000 February salary will be a right or thing, included in your income in the year of death. (Any salary accrued in March to the date of your death will be caught under the above rule under “Accrued wages and similar amounts”.)
As with the deemed disposition rules, any tax resulting from the rights and things rule can be paid in up to 10 annual instalments, with interest.
Alternative treatment for rights and things
Although the regular rule includes the value of the rights and things in your income, there are two alternative rules that may apply.
First, your executor can elect to report these amounts on a separate tax return (although still under your name). The separate tax return will be beneficial because the rights or things will have separate graduated tax rates on those items, rather than being “stacked” on top of your other income in the regular return for the year of death. Also, some personal credits such as the basic personal credit, the spousal credit, the equivalent-to-spouse credit, and the age credit, can be claimed on both the regular and separate return. The election must be made by the later of 1 year after your death and 90 days after the CRA sends the notice of assessment with respect to the year of your death.
You have $300,000 of regular income in the year of death. You also have $40,000 of “rights or things”.
If all the income, including the rights or things, is reported in one return, the rights or things will be subject to the highest marginal tax rate (around 50%, depending on the province). Your personal credits can only be claimed on this return.
If the rights or things are reported on a separate return, they will be subject to the lowest marginal tax rate (about 20-25%, depending on the province). In addition, some of your personal tax credits, like the ones listed above, can be claimed on both the separate return and the regular return, thus eliminating the tax on at least $13,000 of the income.
Alternatively, if the rights or things are transferred to one of your beneficiaries before the election filing deadline, they are not included in your income at all. Instead, they are included in the beneficiary’s income once they are realized.
RRSPs and RRIFs
If you have a registered plan that is a registered retirement savings account (RRSP) or registered retirement income fund (RRIF) at the time of your death, the FMV of the plan at the time of your death is included in your income.
However, if the plan is left to your spouse or common-law partner, it is not included in your income. Instead, it is included in their income. However, they will get an offsetting deduction – meaning no net inclusion and no tax – if they contribute the funds to their own RRSP or RRIF, or to acquire an annuity with certain conditions.
A similar rule applies if you leave the plan to your financially dependent child. If the child is dependent because of a physical or mental infirmity, they can get the offsetting deduction if they contribute the funds to an RRSP, RRIF or to acquire an annuity. If the dependent child is not infirm, an offsetting deduction is allowed only if the child is under 18 years of age, and then only if the funds are used to acquire an annuity payable to age 18.