Canadian inheritance tax: Is there such a thing?
Author: Tom Drake
A common misconception among Canadians is that they can be taxed on money they inherit. The truth is, there is no inheritance tax in Canada. Instead, after a person is deceased, a final tax return must be prepared on income they earned up to the date of death. Any monies owing are paid out from the estate assets before the remaining funds are transferred to the various beneficiaries.
There are other costs involved in settling an estate, however, so it's good to have a basic understanding of how it all works.
Is there an estate tax in Canada?
While there is no such thing as a Canadian inheritance tax, there is an estate tax of sorts. After a person dies, the CRA makes sure that taxes have been paid on any income they earned up to the date of death. If there is a tax balance owing, the executor of the estate is responsible to file a deceased tax return.
For example, let's say Bob passes away on June 30th, 2020. Assuming that Bob's taxes were filed for the previous year, he would be fully paid up to December 31, 2019. But what about the income Bob earned between January 1st and June 30th, 2020? Because the filing deadline isn't until April of 2021, Bob will not have paid the tax on his 2020 income at the time of his passing.
In this situation, the executor of Bob's estate will have to file a final tax return prior to the 2020 deadline, to make sure all of Bob's income has been reported. If there is a balance owing, the executor will need to arrange for payment out of the funds in Bob's estate. If, on the other hand, Bob was due for a refund, the CRA would issue a cheque payable to Bob's estate.
A tip for executors: Once you've filed the final tax return and paid the taxes, make sure you receive a clearance certificate from the CRA. This confirms that there are no further taxes owing, and you can proceed with disbursing the estate assets to the beneficiaries. If you don't receive the certificate, and the CRA informs you down the road that more taxes are owing, you could be held personally responsible for any taxes owing.
How are estate assets treated for income tax purposes?
Any assets included in the estate are considered to have been sold for fair market value at the time of death. This includes any real estate, businesses, land, investments, even RRSPs. It's important to note that each of these assets will generate income differently, and they are not all taxed the same way. Here are a few examples of how the income from estate assets might be treated:
Example 1: Shirley passes away with $230,000 of individual stock held in a non-registered discount brokerage account. It's determined that the stock has an adjusted cost base of $150,000, leaving Shirley's estate with a capital gain of $80,000. Her executor will need to report $40,000 as income on Shirley's final tax return (50% of $80,000).
Example 2: Bob has $50,000 in RRSPs. As soon as he dies, the full balance of his RRSPs are considered to have been sold, generating an income of $50,000. This amount will be included on the final tax return.
Example 3: John has recently passed away. 15 years ago, he inherited the family cottage from his parents, which, at the time of his death, was worth $500,000. When he inherited the cottage, it was worth $350,000. Because John's parents would have paid any capital gains up to the time of him inheriting the cottage, his estate is required to pay a 50% capital gain on $150,000 ($500,000-$350,000). Thus, John's final tax return will need to report $75,000 of additional income for the sale of the cottage.
Example 4: Sue owned a bungalow which she has rented out for the past 3 years. She originally paid $200,000 for the home, and it's now worth $300,000. Sue passed away on March 31, which generated a $100,000 capital gain as of that date. The income reported on the final tax return will include 50% of the capital gain ($50,000) as well as 3 months of rental income, for January to March.
Cases with a surviving spouse
Where there is a surviving spouse or common-law partner, a non-registered capital property can be transferred to them, without a capital gain having to be reported as income. Eventually, when the spouse passes away, the property will be disposed in their name, and the capital gain reported at that time.
With respect to RRSP and RRIF investments, if an eligible person has been named as a beneficiary, then the income from the investment does not have to be reported, and any tax is deferred. Eligible beneficiaries include a spouse or common-law partner, a financially dependent child or grandchild (under 18 years of age), or a mentally or physically disabled child or grandchild of any age.
Cases with no surviving spouse
With no surviving spouse, common-law partner, or other eligible beneficiary, all estate assets are deemed to have been sold at fair market value immediately at the time of death. For real estate properties, a capital gain will have to be reported at 50%. The same goes for any non-registered investment, where the capital gain will be the difference in the market value when the investment was purchased, and the value at the time of death. All registered investments, such as RRSPs and RRIFs, are deemed sold at their full market value upon death. The full balance of the RRSP or RRIF will need to be reported as income on the final tax return.
How are capital gains on investments treated?
As I illustrated in the example above, if the deceased had non-registered investments at the time of death, they would be considered to have been sold at that time. Any income generated by the investment would need to be reported on the deceased tax return. In the case of capital gains, 50% would be considered taxable and added to the estate income.
What is probate?
Often, an estate must go through a legal process referred to as probate. The first requirement of probate is to determine that the will is valid and authentic. Probate also involves the overall administration of a person's will. In situations where a person died without a will, the overall estate. As I mentioned earlier, there is no tax on estate assets, however, provinces do charge probate fees before estate assets are transferred to the beneficiaries.
How do probate fees work?
Probate fees can be complicated, and they vary from province to province. Certain assets in an estate can bypass probate, reducing the final probate cost. An example would be assets with a designated beneficiary, such as a life insurance policy, or most registered investment products, such as RRSPs and TFSAs.
Here's a tip. If you haven't named a beneficiary on your RRSP or TFSA, make sure that you do, if you want to avoid those monies being subject to probate. In lieu of a beneficiary, the funds will be transferred into your estate, and be included in the probate for the calculation of fees. In most cases, joint assets are also excluded from probate, as the joint owner assumes full ownership of the asset. This is most often the case where there is a surviving spouse.
Final thoughts on Canadian inheritance tax
As you are now aware, a Canada inheritance tax does not exist. Instead, the deceased's estate representative must file a tax return for the estate before disbursing funds to the beneficiaries. As a beneficiary, this means that once you've received your inheritance, it's yours to keep.