Unlike the U.S., Canada no longer has any form of estate or inheritance tax. Yet despite this, death can trigger a significant income tax bill that, if not properly planned for, can leave an unexpected liability when a loved one passes away. Here is what happens to your non-registered and registered assets when you die:
Non-Registered Assets
The general rule for non-registered assets is that a taxpayer is deemed to have disposed of all his or her property, such as stocks, bonds, mutual funds and real estate immediately before death at their fair market value (FMV).
When the FMV exceeds the property's adjusted cost base (ACB), the result is a capital gain, half of which is taxable to the deceased and must be reported in the deceased's final tax return, known as the "terminal return." There is an exception for the capital gain arising on the deemed disposition upon death of your principal residence, which is generally exempt.
For example, let's say you die with a portfolio worth $1,000,000 that had an ACB of $400,000. The capital gain on the deemed disposition at death would be $600,000. Since only half the gain is taxable, tax would be owing on a $300,000 taxable gain. Assuming a 45% marginal tax rate for the year of death, $135,000 of taxes would be payable on the terminal return as a result of this deemed disposition.
If you own qualified small business corporation (QSBC) shares, a qualified farm or fishing property upon death, you can claim on your terminal return any remaining lifetime capital gains exemption (currently $750,000 but rising to $800,000 in 2014) against any capital gains arising from the deemed disposition of that property.
Perhaps the best way to avoid or at least defer this deemed disposition upon death is to transfer the property to the deceased's spouse or partner, where applicable. When property is transferred in this way, the transfer can be done without triggering any immediate capital gains and the associated tax liability can be deferred until the death of the second spouse or partner (or until that spouse or partner sells the property, if earlier.)
So, continuing the example above, if you had left your portfolio to your surviving spouse, he or she would be deemed to inherit the portfolio at your original ACB of $400,000, deferring the $600,000 capital gain to the future.
Another opportunity to eliminate the tax arising from the deemed disposition at death is to consider leaving appreciated marketable securities to a registered charity through your will. The capital gains tax is completely eliminated when appreciated publicly listed shares, mutual funds or segregated funds are donated in-kind to charity.
For example, let's say Warren owned publicly traded shares that were worth $30,000 as of the date of his death and had an ACB of $6,000. If he had willed those shares to his favourite charity, the capital gains tax would be eliminated on the $24,000 accrued gain, yielding tax savings of about $5,000, assuming a marginal capital gains tax rate of approximately 20%.
In addition, a charitable donation receipt for the FMV of the shares donated upon death ($30,000) would be issued which could produce a tax savings on the terminal return (or in the prior year's return) of at least 40% ($12,000), depending on his province of residence.
Registered Plans
For many Canadians, however, the largest tax liability their estate will face is the potential tax on the FMV of their RRSP or RRIF upon death. The tax rules require the FMV of the RRSP or RRIF as of the date of death to be included on the deceased's terminal tax return with tax payable at the deceased taxpayer's marginal tax rate for the year of death.
This income inclusion can be deferred if the RRSP or RRIF is left to a surviving spouse or partner, in which case tax will be payable by the survivor at his or her marginal tax rate in the year in which funds are withdrawn from the RRSP or RRIF.
Alternatively, an RRSP or RRIF may be left to a financially dependent child or grandchild and used to purchase a registered annuity that must end by the time they reache age 18. The benefit of doing this is to spread the tax on the RRSP or RRIF proceeds over several years, allowing the child or grandchild to take advantage of personal tax credits as well as graduated marginal tax rates each year until he or she reaches the age of 18. If the financially dependent child or grandchild was dependent on the deceased because of physical or mental disability, then the RRSP or RRIF proceeds can be rolled to the their own RRSP or RRIF.