This series of blog articles will briefly explain tax issues that arise after death. This is the first one.
There are three key points, often regarded as “truths,” that everyone should be aware of:
- Estate planning is essentially tax planning.
- After death, the primary beneficiary is likely to be the Canada Revenue Agency (CRA).
- An individual is deemed to have disposed of their capital property and land inventory at its fair market value immediately before death.
- The death creates Two Taxpayers:
- When the taxpayer is alive
- When a person dies, income earned or deemed to be earned is taxed separately
- Cash basis vs Accrual basis
- These are two different account methods. CRA says that there must be a “change” from Cash Basis to Accrual Basis for the year of death, to accelerate the taxation of income in the year of death, any income that is paid periodically is required to accrue on a daily basis. This means that income earned up to the date of death must be reported in the final tax return, regardless of when the income is actually paid.
- What is Cash Basis (for living taxpayers): Under normal circumstances, living taxpayers can report income on a cash basis. This means they only report income when it is actually received. For example, if a taxpayer purchases a Guaranteed Investment Certificate (GIC) on September 1 that matures and pays interest on February 1 of the following year, the taxpayer would ignore the interest income that accrued by December 31 and report the full interest amount in the next tax year when it is paid.
- What is Accrual Basis (for deceased taxpayers): However, if the taxpayer passes away on December 1, the income accrued from September 1 to December 1 must be reported on the final personal tax return (T1). In this case, the T1 return would report three months of interest income (September 1 to December 1). The interest paid on February 1 would cover the entire five-month period, but the estate would only report the portion of income earned after the date of death (December 2 to February 1) on the T3 estate return. It is important for the estate trustee to ensure this distinction is made correctly, as they often forget to subtract the portion of income that should be reported on the T3 return.
- Deemed Realization:
- Death triggers the deemed disposition of assets at their fair market value.
- Liquidity is essential:
- If the deceased wants to leave their capital assets or shares to heirs without selling them, they need to ensure liquidity from other sources to cover the taxes.
- If a specific asset is bequeathed, other assets in the estate may be used to pay the tax burden to enable the gift to take effect.
- No capital loss is recognized for personal-use property.
- Death triggers the need for a T3 trust return unless the deceased leaves no property.
- At this point, the estate functions as a trust for the benefit of beneficiaries.
- Exceptions: Capital gains cannot be allocated to non-resident beneficiaries, meaning the trust must cover any taxes on capital gains.
- Procedure for Filing a T3 Return:
- The estate calculates income, deducts expenses and fees, allocates income to beneficiaries, and deducts payouts from income.
- If income equals payouts, no income tax is payable.
- When a T3 is Not Required:
- A T3 return is not necessary if the estate’s taxable income is less than $500 or the beneficiaries’ share of the taxable income does not exceed $100.
- A T3 return may also be avoided if the estate is distributed immediately after death and did not earn income beforehand. In these cases, beneficiaries should receive a statement of their share.
- CRA’s Goal:
- It is to ensure the income does not escape the tax system, but if the estate earned no income and beneficiaries report their share, a T3 may not be necessary.
- Trust Taxation Based on Residence:
- Withholding tax must be remitted for non-resident beneficiaries.
A Graduated Rate Estate (GRE) refers to a special tax status granted to the estate of a deceased person for up to 36 months after death. During this period, the estate is taxed at graduated income tax rates, similar to how individuals are taxed. This means that lower amounts of income are taxed at lower rates, and higher amounts are taxed at progressively higher rates. Once the 36-month period ends, the estate is no longer a GRE and is taxed at the highest marginal rate.
For example, if an estate earns $50,000 in income during the first year after the person’s death, it would be taxed at lower rates on the first portion of that income, just like a living person. However, after 36 months, any income earned by the estate would be taxed at the top marginal rate, which is the highest income tax rate applicable to the highest income bracket in the jurisdiction.
The Top Marginal Rate is the highest tax rate applied to income over a certain threshold. In Canada, for instance, individuals or estates with income exceeding a specific amount are taxed at this top rate. For example, if the top marginal rate is 53%, any income earned over a threshold (e.g., $235,675 in Ontario in 2024) would be taxed at 53%, while income below that threshold would be taxed at lower rates.
In summary, a GRE provides temporary tax relief by applying lower tax rates for up to 36 months, whereas the top marginal rate applies to higher incomes and estates no longer qualifying as a GRE.
The principal residence exemption permits a taxpayer and the taxpayer’s immediate family to own and occupy a residence that is capital property, then the capital gain on the actual or deemed disposition of the property is fully sheltered by the exemption.
Key Points:
- The exemption applies to the residence and up to one-half hectare of land.
- Only one residence per family can be designated as the principal residence each year.
- Change in Use: if the use of the residence changes, it triggers a deemed disposition. However, this can be deferred with an s.45(2) election, which can cover up to 4 years (actually, almost 5 years in reality), for example:
- If a family moves out of their home in February 2024 and rents it out starting that month, the s.45(2) election can cover the years 2025-2028; but since the family already lived in the home for a few weeks in 2024, that year of 2024 can also be counted as a principal residence year.
Important Notice:
This blog series provides readers with a basic and general understanding of estate tax issues. If you encounter estate tax matters in your personal situation, it is crucial to consult with your lawyer or accountant. As always, it’s better to leave professional matters to the professionals.