Death and taxes: What you need to know

Canada doesn’t levy succession duties or gift, estate and death taxes. Still, income taxes in the year of death can be quite significant. They’re inescapable, and should be factored into your financial or estate plan.

Death of a taxpayer

Two rules govern taxation in the year of death. First, worldwide income earned and accrued from January 1 to the date of death is reportable on the final (terminal) T1 tax return.

This includes investment and employment income. All accrued income amounts must also be included on a per-diem basis. Plus, the fair market value of all RRSPs/RRIFs has to be included in the income for the year of death.

Second, a deceased taxpayer is deemed to have disposed of capital property immediately prior to death for proceeds equal to fair market value. Capital gains and losses must also be reported on the terminal T1. To determine the gain (or loss), you have to know the adjusted cost base and fair market value of each capital asset.

For many, the final tax bill will be the highest. The deemed realization at death under the Income Tax Act is, in essence, Canada’s death tax. That’s why the disposition rule provides the backdrop for most estate-tax planning; and, luckily, the rules contain certain potentially ameliorating provisions: rollovers, exemptions and elections.

Rollovers

A common rollover, involving transferring assets to a surviving spouse, is available for capital property and RRSPs/RRIFs.

It allows these assets to be transferred to a surviving spouse (via the will, joint ownership with right of survivorship, where applicable, or beneficiary designation) with no immediate tax consequences. Instead, the usual deemed disposition will be deferred until the death of the surviving spouse.

Note, the rollover can be made to a spouse or a qualifying spousal trust (for income-tax purposes, “spouse” may include legally married, common-law and same-sex couples). Other possible rollovers include family farms to a child or grandchild and RRSPs to a dependent minor child or grandchild.

Exemptions and elections

The most significant exemption for most taxpayers applies to the principal residence. Possible elections include filing additional tax returns in the year of death and splitting certain types of income. If you use these techniques prudently, you can save taxes for the estate.

Tax rules require all income be captured somewhere. As a result, income earned after death must be reported in either a trust return or the beneficiary’s personal return.

Even if the deceased did not leave a will (or the will he left didn’t establish testamentary trusts), there is generally post-death income and, more often than not, the estate will need to prepare and file at least one T3 trust return. Post-death income may include investment income or income from rental properties.

One of the most common examples of post-death income is the CPP death benefit; which maxes out at $2,500 and must be reported by the recipient. It cannot appear on the deceased’s terminal T1 return.

But, if the recipient’s in a high tax bracket, it may make sense to report the death benefit on aT3 trust return in order to take advantage of the lowest graduated rate.