You have spent your life working hard and accumulating wealth for you and your family to enjoy. While you are living you pay taxes annually on both your earned and investment income. But did you know that your assets may also result in a tax liability upon your death or the death of your spouse? In Canada, a taxpayer is deemed to dispose of all of his or her assets at death. If the value of these assets exceeds their cost, then, without proper planning, taxes could be payable.
But the good news is, it might be possible to reduce or at least delay the payment of this tax by organizing or re-allocating certain assets that would result in a tax liability at your death. There is also a way to cost effectively accumulate tax-free funds to pay all or part of any taxes that may become due upon your death.
Of course, every situation is different, so you should consult with a financial advisor before making any big decisions. Below is a simple guide that will help you structure your estate in the most tax-advantageous method.
Most people are aware of what assets they own, but let’s separate them into two different groups to better understand how they are treated at death.
Assets That Could Result In A Tax Liability
Real estate, other than your principal residence, for instance, is subject to capital gains tax on your final tax return. For example, perhaps you bought a vacation home in 1990 for $100,000, but when you die it is valued at $500,000. There is a deemed disposition resulting in a capital gain of $400,000 of which half is taxable in the year of your death. If your real estate was rental or commercial property, you may also be subject to additional tax at death in the form of recaptured depreciation.
Other assets that give rise to capital gains at death include shares in public and private corporations, farms, antiques and other collectables. If the private company shares are of a Qualifying Small Business Corporation, the first approximately $900,000 of capital gains could be received by a Canadian resident tax free. For qualifying farm or fishing property the first $1,000,000 of capital gains may be tax-free.
There is a provision under the Income Tax Act that states that the taxes arising from capital gains at death can be delayed by leaving the assets to a spouse. In doing so, the tax will be deferred until the spouse disposes of the assets or dies.
Registered assets such as RRSPs, RRIFs, pension plans are also deemed to be disposed of at death with the full balance being taxable as income. This is in addition to any withdrawals or income payments made in the year of death. Again, a taxpayer can name a spouse as beneficiary to allow those registered plans to be rolled over into the spouse’s registered plan avoiding tax in the year of death.
Assets That Do Not Result In A Tax Liability
There are generally four types of assets which are not subject to tax at death. These are your principal residence, Tax-Free Savings Accounts, the tax-free portion of capital gains, and the death benefit of a life insurance policy.
Financial vehicles such as TFSAs, RSPs, and life insurance allow for the naming of a beneficiary. When this is done, the proceeds at death pass directly to the named beneficiary outside of the will. This results in no probate fees or administrative costs being assessed on the value of these assets as well.
Death And Taxes
It is difficult to completely eliminate a tax liability upon death. However, there are options you have to help the estate pay your final tax bill, while still providing for your heirs. Below are some common strategies for dealing with the ultimate tax bill.
Building a Cash Reserve
There is nothing wrong with saving money. Saving money or building a cash reserve to pay taxes at death, however, is not a very viable option. For one thing you don’t know for certain when the funds are going to be needed or how long you have to save for it. Saving doesn't buy you time and often the money doesn’t stay saved. If you are looking to save specifically to pay for taxes at death, you would be much better off paying life insurance premiums.
Needing to sell assets to pay taxes at death can result in a “fire sale”, with property realizing less than their full value. Another consequence of liquidation is that the asset is no longer available for future growth and income for the benefit of the heirs. Often the sale of an asset results in even more taxes and expenses. Unfortunately, without adequate life insurance there may not be any other option.
The death benefit of your life insurance is paid tax-free to your beneficiary, and your policy could provide liquidity to your estate when your heirs need it to pay the tax liability associated with other assets. This is a solid strategy used to mitigate tax burdens associated with an estate while at the same time providing for last expenses, such as debt and funeral costs, in addition to creating future income for the family.
Freezing the Estate
For larger estates, an estate freeze might be implemented which “freezes” the value of the estate and passes the future growth onto the next generation. This can be a complicated and expensive process but for significant estates the future tax savings can be substantial.
Borrowing to Pay the Tax
On those occasions where no prior planning has been implemented, an executor might seek to borrow in order to pay the taxes due at death. Apart from the necessary collateral that would have to be pledged, one big downside to this option is the fact that the loan has to be repaid with interest. At the end of the day, the loan and interest payments would total much more than the amount of the tax. This might be an option if none other was available but it is definitely not a desirable one.
Questions about your estate?
Your estate having to pay taxes upon your death is a testament to your success. That’s the good news. How much bad news there is can be greatly reduced or even eliminated by proper estate planning that an experienced financial advisor can help provide. Remember, the sooner the planning begins the better the results that can be achieved.
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