Many Canadians find financial planning and tax confusing. When tax complexity is further increased by the addition of estate planning, one might be tempted to throw up their arms in submission and shout, “I don’t care about estate taxes! I won’t be the one paying them!”
While this may be true in a literal sense, it is not entirely accurate from an administrative perspective. When we pass away, we still have to pay our final year of taxes, which is typically done by our executor. In a way, we are paying taxes as "zombies."
However, unlike zombies, our executors have brains and can make decisions. Nevertheless, they may not have much flexibility when it comes to implementing tax-saving strategies once we have passed away. The best approach to tax planning for estates is to plan while we are still alive.
To become good planners, we need to have a basic understanding of estate tax. This article aims to provide the fundamentals, but we always recommend seeking personalized advice from professionals.
Estates & Taxes
When someone passes away, their assets such as real estate, personal property, securities, and others, make up their estate. The legal process of settling the estate involves transferring ownership to the rightful surviving beneficiary(ies). However, before this transfer can occur, any taxes owed on the gross value of the estate must be paid. It's important to note that the estate is responsible for paying these taxes, not the beneficiaries. Once the taxes are paid, beneficiaries will receive the after-tax residue, meaning they will not inherit any debt or taxes from the deceased individual’s estate (more on this below).
How are taxes calculated on an estate?
When an individual passes away, there is a deemed disposition for tax purposes of all taxable assets, except in the case of joint ownership with right of survivorship or where a special provision applies. A deemed disposition means that all assets solely owned by the deceased are considered sold, which can trigger any unrealized capital gains or other deferred taxes. The estate must keep track of and settle these taxes before distributing the remaining assets to the beneficiaries.
What are “special provisions?”
There are certain situations in which tax is not triggered after someone's death, although there are usually few specific rules governing these cases. One common exception is the spousal rollover provision, which enables a spouse to transfer qualified assets to the surviving spouse on a tax-deferred basis.
To illustrate, suppose I pass away and my spouse is designated as the beneficiary of my retirement plan. Under the spousal rollover provision, my wife can inherit my Registered Retirement Savings Plan (RRSP) without having to pay taxes on it immediately. Later, she can withdraw funds from the RRSP and pay taxes at her marginal rate. However, if there are any unused funds in the RRSP when she dies, they will be subject to a deemed disposition.
We now understand the basics of the estate calculation:
Gross Value of Estate on Date of Death
– Taxes Owed, Probate Fees and Estate Expenses
= Net Estate to Heirs.
Next, we’ll break down some specifics for added clarity.
Tax treatment of assets & accounts in an estate
Tax-deferral vehicles.
If I have a Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), or other similar tax-deferral vehicle (LIRA, LIF, etc.), and no special provisions apply, then the full value of these will be considered sold and treated as income in my year of death. This income will be subject to taxes at my marginal tax rate and will be added to any other taxable income earned in the year of my death. My estate's executor will report all of this on my final tax return.
For example, if I have $1,000,000 in my RRSP, the full amount will be considered as income in my terminal year. In most provinces, around 50% of this amount will go towards taxes, leaving my beneficiaries with an inheritance of approximately $500,000.
By contrast to the above, another registered account, the Tax-Free Savings Account (TFSA), is funded with after-tax dollars and is therefore tax-sheltered. This means that when I die there will be no unrealized gains due.
Non-registered assets.
Non-registered assets include investments such as stocks, bonds, mutual funds, real estate, and other types of assets that are owned outside of registered accounts. Any non-registered assets which have a fair market value higher than their cost base and have yet to pay the tax due on these assets will owe tax on death.
For instance, if I had $1,000,000 of Microsoft shares for which I had only paid $500,000 originally, I would have a gain of $500,000. Luckily, capital gains have half of the gain exempted from tax, so really my taxes will only be assessed on a gain of $250,000. Assuming a 50% marginal tax rate, that’s $125,000 total tax, leaving my estate with $875,000[i].
Example of Estate Distribution for Hypothetical Microsoft Shares[ii]
Considerations specific to Real Estate
Similar to above, if I passed along appreciated real estate instead of stocks/shares, the same calculation would apply; the estate would owe $125,000 in taxes before the real estate could be transferred to my beneficiary(ies). The similarity ends here. Let’s highlight some key differences:
Liquidity: Real estate is considered a less liquid asset compared to publicly-traded shares, which means that it cannot typically be sold as quickly or easily. In the event that the estate owes taxes, the executor may need to consider whether the estate has other sources of capital to cover the tax bill, or if the property needs to be sold to generate the necessary funds. If selling the property is the only option, the executor must determine an appropriate sale price and weigh the associated costs while also estimating how long it will take to complete the sale.
Given the illiquidity of real estate, those planning to pass on such assets to their heirs often ensure that their estate has alternative sources of liquid capital to pay for estimated taxes. These sources could be the after-tax value of other assets or proceeds from life insurance. However, if alternative liquidity is not available, it's possible that a cherished family property may have to be sold to cover the tax liabilities.
Transfer Costs: If the property is transferring to an heir, there could be legal fees and costs on the transfer of ownership. If the property wasn’t my principal residence and/or doesn’t qualify for the Principal Residence Exemption (PRE), there will be property transfer tax charged which can be material ([iii]in BC, it is about 1-2% of the fair market value of the property).
Speaking to a qualifying Principal Residence property, one nice thing for those who own their homes on death is that the PRE remains. This means that the estate shouldn’t need to concern itself with any unrealized capital gains on the principal residence as it will remain exempt from this calculation[iv]. The only costs to factor in would be those involved with the transfer of ownership (legal fees, land transfer tax, etc.)
Probate
Apart from the tax considerations mentioned earlier, another important factor to consider is probate. Probate is a legal process in which a person's Will is proven in a provincial or territorial court, allowing their estate to be distributed to the beneficiaries named in the Will. This process ensures that the Will is accurate and legally valid and that all assets and debts are accounted for before distribution takes place.
Now that we have discussed what probate entails, let’s consider probate tax.
Probate Tax
Probate taxes vary from province to province, but they are typically a small percentage of the deceased person's estate. In British Columbia, where I reside, there is a tiered structure that can be simplified as follows: for estates worth more than $50,000[v], the probate tax is 1.4% of the probated estate.
To illustrate, let's consider the example of the Microsoft shares I left in my estate, which are worth $875,000. In this case, my estate would need to pay an additional $11,550 in probate tax before the shares can be distributed, either in-kind or in cash.
What is encompassed in the Will (subject to probate)?
The Will covers personal assets that are solely owned at the time of death and don't have designated beneficiaries or other ownership arrangements. This usually includes one's primary residence, personal property such as furniture, art, vehicles, collectibles, and non-registered investments.
While registered investment accounts or insurance policies can be included in the Will, doing so may result in the loss of tax benefits or create legal complications if it conflicts with beneficiary designations already in place for those accounts. As such, it's typically recommended to keep registered accounts and insurance policies separate from the Will.
What can be passed to heirs outside of the Will (outside of probate)?
To reiterate, anything that already has an established means of ownership or beneficiary designation will typically not be included in the Will.
- Joint-Title Assets: Joint ownership of assets can take two forms: Joint Tenancy in Common (JTC) and Joint Tenancy with Right of Survivorship (JTWROS). When it comes to real estate, these types of ownership are usually referred to as Joint Tenancy in Common and Joint Tenancy with Right of Survivorship.
In the case of Joint Tenancy in Common, each owner has a specific percentage or share in the asset, which may or may not be equal. Each owner can sell, transfer, or borrow against their share without the consent of the other owner(s). In the event of the death of one owner, their share of the property would pass to their heirs or beneficiaries, rather than automatically transferring to the surviving owner(s). In an estate situation, the estate will treat the proportionate ownership of the JTC asset in isolation, as though it were a sole-owned non-registered asset. First, any unrealized taxes are due by the estate, and then the ownership/residual value of the asset may be passed along to heirs.
On the other hand, Joint Tenancy with Right of Survivorship means that each owner has an equal share in the asset. When one owner dies, their share automatically passes to the surviving owner(s) without going through probate. This means that if one owner passes away, their share of the property is transferred to the remaining owner(s) outside of the deceased's estate. This type of ownership is common for assets such as real estate, non-registered investments, and bank accounts.
However, it's important to note that simply adding another party as joint owner to an asset prior to death is not always a tax-savings strategy. Adding someone to the title of a non-registered asset can trigger a taxable disposition at that time, which means taxes must be paid. Unfortunately, this step is often overlooked by those undertaking the transaction, such as an adult child adding themselves as a joint owner to a parent’s self-directed brokerage account. Technically speaking, the adult child should be recording a taxable disposition from parent to themselves, for the proportionate ownership of the account they are adding themselves onto and paying the appropriate amount of tax.
Moreover, if a disposition was not correctly recorded when the title/ownership change was undertaken, the Canada Revenue Agency (CRA) may retroactively assess the transaction and chargeback taxes and penalties they deem owed. - Life Insurance: If an insurance policy names a beneficiary(ies) directly, then the death benefit proceeds are paid outside of the Will.
Note that while not ideal, it is possible to name an estate as a life insurance beneficiary. Naming the estate as beneficiary makes it part of probate and will therefore incur probate taxes. - TFSA: A TFSA which names a beneficiary(ies) directly is also settled outside of a Will. As with life insurance, it is possible to name an estate as beneficiary. Again, this is not usually desirable as it would be subject to probate taxes.
- RRSP/RRIF: These accounts that name a beneficiary(ies) will usually be disbursed outside of a Will[vi]. Yet again, it is possible to name an estate as beneficiary, likely reducing some of the intended benefit due to probate.
- Registered Education Savings Plan (RESP): To clarify, it's important to note that an RESP is not considered a formal trust, and therefore, it's not automatically inherited by the beneficiaries (the individuals whose education is being saved for) when the subscriber(s) (the person or persons who set up and contribute to the RESP) pass away. The rules regarding the inheritance of RESPs vary by jurisdiction, but in general, if there is a surviving joint subscriber owner or a named successor subscriber, the RESP can pass outside of the Will. In this case, the named individual(s) will inherit control of the RESP and can continue managing it for the benefit of the beneficiary(ies).
Case Study
To help put this all together, let’s assume a fairly common estate structure and work through its settlement. We’ll take the example of a 90-year-old widow who owns the following, all in sole ownership on date of death, and has one surviving adult child (“Adult Child 1”):
Now let’s work through the steps of how the assets will be settled in and outside of the estate.
1. The TFSA and life insurance combined will pay $1,100,000 directly to Adult Child 1 free of any taxes and probate.
2. Because of the RRIF, the terminal tax return will have taxable income of $500,000 (plus any other income already received in the year of death).
- At a 50% tax rate, this would be $250,000 of tax paid in the terminal tax return. The residual $250,000 passes along to Adult Child 1 with no further tax considerations.
3. The unrealized gains on the Vacation Property and Common Stock Shares will be triggered.
- Taxable gains are ($250,000 + $50,000) x 50% capital gains exemption.
- At a 50% tax rate, this results in $75,000 of capital gains taxes being due.
4. Assets subject to probate include the Principal Residence, Vacation Property, Common Stock Shares and Bank Account.
- Using a simplified example of the BC probate tax, that would be (($1,000,000 + $750,000 + $100,000 + $50,000) - $50,000) x 1.4% = $25,900 probate tax due.
5. The executor can sell the Common Stock Shares and use the after-tax funds ($75,000), along with those in the Bank Account ($50,000), to cover the capital gains tax and probate tax due.
- $125,000 - $100,900 = $24,100 net residue in the estate.
6. Following probate, the estate has a principal residence worth $1,000,000, a vacation property worth $750,000 and $24,100 in cash assets.
- Let’s assume Adult Child 1 does not own a principal residence of their own, so will be inheriting their mother’s principal residence tax free under the principal residence exemption. They will only need to cover costs of title change (~$1,500) which they can do from their TFSA and/or Life Insurance proceeds.
- Let’s also assume that the vacation property pays 2% total in fees/taxes to transfer title of the real estate to Adult Child 1. This would be $15,000 in costs, which can be paid by the executor from the $24,100 in cash on hand, bringing it to $9,100.
7. Upon settlement of the estate, Adult Child 1 gets the Principal Residence, the Vacation Property, and the cash residue of the estate. They add this to their TFSA and Life insurance proceeds, plus the after-tax RRIF proceeds. At the end, there has been $367,400 of tax and costs paid, leaving Adult Child 1 with the following:
Conclusion
As demonstrated, estate planning is a complex process that requires careful consideration of various factors. However, this information only scratches the surface of what is involved in the process. It cannot provide specific guidance on how to plan for the potential outcomes that can arise from these competing variables.
Individuals who plan to leave assets to their heirs, particularly those with significant value, should seek the advice of professionals who specialize in financial planning, tax planning, and legal planning. It is crucial to engage with these professionals well in advance to ensure that the estate is settled according to the individual's wishes. Failing to do so or leaving it for the "zombie you" to deal with will likely result in a less-than-desirable outcome.
[i] Simplified for illustrative purposes. Does not account for probate, tax, and other potential considerations in estate. Only intended to illustrate the first level of tax consideration on an unrealized gain with non-registered share ownership.
[ii] Simplified for illustrative purposes. Does not account for probate, tax, and other potential considerations in estate. Only intended to illustrate the first level of tax consideration on an unrealized gain with non-registered share ownership.
[iii] https://www2.gov.bc.ca/gov/content/taxes/property-taxes/property-transfer-tax/calculation-examples#general-ptt
[iv] There’s a bit more complexity to the PRE calculation than this, but for most Canadians who only own one home, it will be essentially this simple. For more information please see: https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-1-individuals/folio-3-family-unit-issues/income-tax-folio-s1-f3-c2-principal-residence.html
[v] https://www.bclaws.gov.bc.ca/civix/document/id/complete/statreg/00_99004_01
[vi] There are some examples of court cases where the court has ruled that RRSP/RRIFs were being held “in trust” for beneficiaries and thus formed part of the probated estate rather than being able to be distributed directly according to beneficiary appointments. These are outside the scope of this article but are being noted since rare exceptions do occur. Always employ a qualified legal professional when considering personalized tax and estate advice.
