Unlike in the United States, Canada does not have an “estate” or “inheritance” tax. However, death can still trigger a significant income tax bill. When you die, your executor needs to file your final tax return, known as your “terminal return”, which covers the period from January 1st of the year of death to the date of death. Included in this return is the income earned during that period from such things like pensions, CPP and investment income. But what most people don’t factor in is that you need to also account for any unrealized gains in your non-registered investments and the value of your registered accounts. The level of income tax that ends up being paid on that final tax return can be a big surprise to executors and heirs.
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, pooled 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 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 many Canadians, however, the largest tax liability their estate will face is the potential tax on the value 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 as income on the deceased’s terminal return. Tax is payable at the deceased taxpayer’s marginal tax rate for the year of death.
The Tale of Two Deceased Taxpayers.
To highlight this, let’s look at the income and resulting taxes on the final returns of two deceased taxpayers with the same overall gross net worth of $1,865,000 but with a different composition of asset types. Deceased A’s executor will pay less tax out of the estate for the final tax return because the RRIF is smaller than Deceased B’s RRIF. Both taxpayers in these examples have the same level of realized capital gains from their non-registered portfolios.
For retirees that have large registered accounts, the best way to minimize income tax on death is to live a long and fruitful life in order to draw down that RRIF over time and pay tax at marginal rates every year. It is important to keep in mind that registered accounts are not actually worth as much as their market value indicates because taxes have yet to be paid on the balance.
The other important consideration to note is that both the deemed disposition on non-registered investments and the income inclusion from the registered accounts can be deferred if the assets are left to a surviving spouse or partner, in which case the amounts will be included in the survivor’s final tax return when they are deceased. DCW