Planning for leaving an inheritance is necessary to avoid or reduce the taxes that an estate pays at death, says John Natale, Assistant Vice-President, Tax and Retirement Services, Manulife Investments.
“In Canada you’re deemed to have disposed of your assets right before death,” he says. “From a tax perspective, we call that a ‘deemed disposition.’ If you have non-registered assets, you’re deemed to have sold them at their fair market value, so you could trigger a capital gain or a capital loss.” Those non-registered assets could include a cottage, investment property, stocks, mutual funds or segregated fund contracts held outside of a Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), Tax Free Savings Account (TFSA) or pension plan.
Someone who held 1,000 shares of a bank stock purchased at $3 a share and now worth $6 a share would have realized a taxable capital gain. “Your market value is six dollars a share, your cost base is three dollars a share, so the difference [($6 - $3) x 1,000 shares] is a $3,000 capital gain. One half of that gain is taxable and would be reported on your final tax return, also called your terminal tax return.” (The executor of the estate is responsible for filing the tax return.)
But those taxes can be deferred with proper planning, Mr. Natale says. An asset can be transferred “in kind” (as is) to a spouse, or a trust can be created for that spouse, and the spouse or spousal trust would take ownership at the original cost paid by the deceased. Taxes would be deferred until the spouse or spousal trust sells the asset, or until the spouse dies; the taxes would be based on the gain at that point in time.
“With spouses, there’s a tax-free rollover,” Mr. Natale explains, because if a spouse is joint owner of an asset, ownership would be passed on automatically at time of death, and the assets would be deemed to have been sold at their adjusted cost base. “That would be an exception to the ‘deemed disposition’ at fair market value rules.”
Registered assets such as RRSPs or RRIFs also trigger tax consequences at death. “Whatever the value of your RRSP or RRIF assets are on the date of your death is deemed to be included in income,” Mr. Natale says. “It’s as if you withdrew them all at that time. There are some exceptions to that rule, but that’s the starting general premise.”
These taxes may also be deferred if your RRSP or RRIF beneficiary is your spouse, or minor or disabled child or grandchild. “If someone passes away with an RRSP/RRIF and his beneficiary is a spouse, or a financially dependent child or grandchild, whether they’re a minor or have a physical or mental infirmity, that RRSP/RRIF could be transferred to another registered asset in that beneficiary’s name and there would be no net income inclusion to the deceased,” Mr. Natale says.
Tax consequences would be triggered at time of withdrawal however. “The RRSP/RRIF funds retain their character. They are treated the same way as when the original person held them so when a dollar is withdrawn from the registered asset held by the beneficiary it’s taxable.”
Another strategy is to transfer non-registered assets such as a family cottage to the children now. The tax consequences would be triggered in the current tax year, but any future growth in the value of that asset would not be taxed at death. “Let’s say that individual lives another 10 years. By transferring the cottage to the children now, any growth between now and 2022 would no longer be the estate’s responsibility. It would now be in the childrens’ hands.”
A more complicated strategy is to set up a family trust. “The trust is a separate taxpayer. If you set it up properly, it might be able to use a separate principal-residence exemption.” But “you’re going to incur fees to set up and maintain the trust. This is for people with a little bit more wealth, who do the cost-benefit analysis and see value in incurring these fees to engage in this type of planning.”
Probate fees or taxes, which vary by province, are triggered when a will is submitted to a court for verification, but these fees can be reduced with proper planning and strategies, Mr. Natale says. (Probate does not apply in Quebec.)
“Probate avoidance is a common part of estate planning. One way is to name a joint owner – on a bank account, or a home. On the death of one joint owner, ownership automatically transfers to the surviving joint owner and therefore does not go through the estate, is not dealt with under the will, and is not subject to probate fees. Any investment that allows you to name a beneficiary, such as an insurance product or an RRSP or RRIF in all provinces outside of Quebec (in Quebec this applies only on insurance investments), can avoid your estate and probate fees. The cheque will be made directly to that beneficiary.”
But, he cautions, “Sometimes people spend so much time and effort trying to save probate fees that they lose sight of the big picture. They may even incur more fees in planning than what the probate costs would have been, and there may be disadvantages to these strategies or not dealing with the assets through your will. But if you can, all things being equal, why wouldn’t you want to save up to 1.5 per cent (depending on the applicable provincial probate fees) of the value of your estate?”
 All references to spouse include common-law partner as defined in the Income Tax Act (Canada)