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Some Canadians entering into their later years are opting for common-law relationships rather than marriage for a variety of reasons.
But, like marriage, this relationship status has financial and tax-related implications that can affect everything from a person’s pension plan to the transfer of assets should a spouse or partner pass away.
“What we see is that with changes in marital status, Canadians tend to focus on the potential legal implications,” says Michelle Seymour, managing director, wealth planning, at ATB Wealth in Calgary. “However, taxes may be overlooked and there are, in fact, immediate tax implications.”
That’s why it’s important to know the definition of common law under the Canada Revenue Agency (CRA) as it differs from other legal definitions, such as family law, and prepare for how the relationship may affect clients, their finances and future.
The definition of common law as the CRA outlines involves couples who have lived together in a conjugal relationship for more than 12 continuous months, with no more than a 90-day separation during that time. Revenu Quebec offers a similar definition.
“Some people are just unaware of that 12-month timeline,” Ms. Seymour says. For that reason, the most basic place to start when looking at the shift to common-law status, she adds, is recognizing when to declare the status change to the CRA and start filing taxes as a household.
Clients want to avoid making a mistake around that as they may be found guilty of filing a fraudulent tax return. Each person must file their own individual tax return with their marital status indicated on the form.
From a tax perspective, there are pros and cons to reaching common-law status, much the same as entering into a marriage.
Specifically for older individuals and those who are retiring, pension income splitting is a way to reduce taxes on an overall household basis, so common-law spouses could save, says John Waters, vice president, director of tax consulting services at BMO Nesbitt Burns Inc. in Toronto.
“It allows for people who are receiving registered pension plan income or if they’re 65 years of age or older receiving [a registered retirement income fund (RRIF)] income, to split that income up to 50 per cent with their spouse or common-law partner,” Mr. Waters says.
He points out that it can be very beneficial for retirees and seniors to be able to split income as a family unit. “Whereas if you’re just on your own, it’s all in your hands.”
Age is definitely something to keep an eye on when looking at registered retirement savings plan (RRSP) contributions as those aged 71 and older can no longer contribute to their own plans and must convert them into a RRIF, an annuity or simply cash them out before the end of the year in which they turn 71.
However, if there is a younger spouse or common-law partner aged 71 or under, and the client continues to have earned income (or unused RRSP room), they may contribute to their spouse or common-law partner’s RRSP until the end of the year in which they turn 71, regardless of the client’s age.
In addition, Mr. Waters says it can make a big difference for their RRIF payments “as they have the ability to base their payments on the younger spouse or common-law partner’s age, which could reduce the amount they have to take out as a RRIF minimum each year.”
Lower payments leave more money invested in a RRIF, resulting in less current tax and the potential for prolonged tax-sheltered growth.
In terms of estate planning, clients are generally deemed to have disposed of everything they own at fair market value the immediate second before they pass away and, therefore, they would trigger all capital gains or losses as the date of death, Mr. Waters says, highlighting that a notable exception occurs if they transfer to their surviving spouse directly or a qualifying spousal trust.
“In that scenario, they can defer the capital gains tax,” he says. “That’s a biggie because otherwise, their estate’s paying a potentially large tax bill, but if they transfer it to a surviving spouse or common-law partner, they can defer that until the partner disposes of it or passes away.”
The drawbacks when it comes to real estate
There are also tax implications that could be detractors for some when considering common-law status, like principal residence status, says Allison Marshall, vice president, high-net-worth planning services at RBC Wealth Management in Toronto.
“Let’s say one individual has a cottage that they’re claiming as a principal residence, another person has a place in town, and they decide to cohabitate. They don’t get to claim one principal residence per individual,” Ms. Marshall explains. “Once they’re common law, they only have one principal residence exemption between them for each year that they are determined to be common law.”
Down the road, that could result in a lot more taxes payable once the property is disposed of, adds Ms. Marshall, or at death, when the client is deemed to have disposed of that property.
She points out that another thing to consider under the Income Tax Act is attribution, which is a set of rules that prevents taxpayers from reducing taxes by shifting investment income to family members.
“As Canadians, we are all taxed individually,” Ms. Marshall says. “However, there’s a set of rules that prevents you from income splitting in ways that the government deems inappropriate.”
She explains that spouses fall under a certain set of rules of attribution whereby if they have a property that’s gifted for no consideration or loaned at a low or no interest rate between two common-law spouses, then the attribution of the income comes back to the contributing spouse.
“If that contributing spouse is in a higher tax bracket, they could potentially be paying a higher level of tax,” Ms. Marshall says.
“That’s why understanding how income tax is going to apply to their situation is very individual to their specific circumstances.”
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