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How to reduce the tax hit on an inheritance

Gary is a good friend of mine. He approached me this week saying "Tim, I want to speak to you about the day when we won't be here any more."

I looked at him and replied "You mean next week, when you and Susan leave for your trip to Europe?"

"Not exactly," he replied. "I'm talking about when Susan and I answer the last call. You know, when we've cashed in our chips, bought the farm, checked into the Wooden Waldorf, climbed the golden stair."

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"Ah, I get it," I said. "Next week you're planning on going to a casino, winning some money, cashing in your chips to buy a property somewhere – the south of France maybe? – after which you're going to travel to a Waldorf hotel just so that you can see a particular staircase? Sounds like an interesting vacation Gary. Sure, let's talk about what you'd like me to do when you're away. Want me to collect the mail?"

We then chatted about his real concern: What is going to take place after he and Susan have passed away. You see, Gary experienced the death of his mother three years ago, and winding up the estate got a little messy. His mother paid a lot of tax on her death, and there was a missed opportunity that Gary learned about later that could have saved the family thousands in tax. He wants to make sure his executor doesn't miss the same opportunity.

Declining values

Gary's mother passed away on May 15, 2008, at a time when she owned a $2-million investment portfolio. Her cost amount adjusted cost base (ACB) for that portfolio (the value when first purchased) was just $1.2-million. Since she had no spouse to leave her assets to, the kids inherited the portfolio and the assets were deemed to be disposed of at fair market value at the time of her death. This triggered an $800,000 capital gain, and a tax bill of $185,640 on her final return. (the highest marginal tax rate in Ontario). Following his mother's death, that portfolio dropped in value to just $1.4-million.

The estate was distributed to Gary and the family, and the portfolio was worth $1.4-million at that time. The cost amount to the family was $2-million – the value at the time of his mother's death. The problem? The family inherited the portfolio with an unrealized capital loss of $600,000 (the $2-million cost amount less the fair market value of $1.4-million when they received the assets from the estate). Each family member will have to generate substantial capital gains in the future in order to use up those losses.

A better idea

There is a little-used provision in our tax law which could have helped Gary and his family. You see, any income, gains, or losses realized by the estate after the death of an individual will normally have no impact on the final tax return of the deceased. Our tax law, however, makes an exception in the case of capital losses that are realized after an individual's death. Here's how it works: Subsection 164(6) of our tax law will allow any capital losses realized in the first taxation year of the estate to be carried back and applied against any capital gains that might have been reported on the deceased's final tax return. In the case of Gary's mother, the executor could have sold the investments after they dropped in value to realize the $600,000 capital loss, then he could have carried the loss back to offset most of the $800,000 capital gain so it was instead $200,000 reported on his mother's final tax return. This would have saved $139,230 in taxes – from $185,640 to $46,410 – on her final return, money that Gary and his family would have liked to have.

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The nuances

It's important that the executor actually realize the capital loss by, typically, selling the assets that have dropped in value since the date of death. This should be done before the estate is wound up and a distribution of the assets is made to the beneficiaries.

It's also important that the executor avoid having the estate repurchase any of the investments within 30 days of any sale, otherwise the superficial loss rules will kick in and deny the capital loss (it's not a problem if one of the beneficiaries acquires the same securities at any time).

Finally, the capital loss must be realized in the first taxation year of the estate. Be careful when choosing the taxation year-end of the estate (it can fall any time up to the first anniversary of the date of death), because an early year-end could limit the time period during which the executor must make the sale.

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