How to reduce the ultimate departure tax
Once you're dead, there's nothing your heirs
can do to keep the taxman at bay, which
is why it's critical to plan now.
Net Worth examines how estates get
treated by Ottawa, and some strategies
aimed at reducing the tax bill.
ANDREW BELL
Investment Reporter
Saturday, June 12, 1999
So what's the story on taxes when your parents leave you property, cash and investments?
First, the good news. Heirs pay no taxes -- it's all charged to the estate. The bottom line is: Taxes aren't levied on the value of the legacy but on any increase in value since the goods or investments were first bought. Ottawa doesn't grab a cent of cash bequests, the house gets passed on tax-free, heirlooms are probably safe from the taxman, a business or farm can often be rolled over scot-free, and life insurance policies get paid out unscathed.
Nice.
But you didn't suppose it would all be that easy, did you?
Canada levies no death, estate or inheritance taxes as such. But a dead person must have a final or "terminal" tax return filed for them -- within six months of death or by April 30 of the following year, whichever is later -- and Revenue Canada assumes the taxpayer sold everything at the last moment of life and also cashed in any tax-sheltered savings plans.
That "deemed disposition" rule applies even if the belongings are willed directly to an heir and not sold off. But the tax liability applies to the estate, which is taxed at the same rates as the deceased.
If there isn't enough cash or life insurance in the estate to cover taxes, assets must be sold.
And with exceptions for spouses and children, the cashed-in registered retirement savings plans get fully taxed as income, often at the dead person's top marginal rate, just as individuals who take money out of their RRSPs must include the money in that year's income. (Stop whining: after all, there was juicy tax relief on contributions to the plan as well as tax-free growth over the years.)
Sorry, you're not out of the woods yet. The provinces take a rakeoff of nearly all bequests in the form of "probate" levies that amount to an inheritance tax. Those fees range from nothing in Quebec to a whopping 1.5 per cent of the estate in Ontario (which works out to $7,500 on a fairly modest $500,000 bequest).
In theory, the fees are an administrative charge for carrying out "probate" on an estate -- basically court certification that an executor is duly appointed to administer the will. Not all estates need probate, but brokers and bankers, to cover themselves, usually demand it before they'll release assets.
What you pay
Here's a rundown of the tax charged against different assets when they're inherited. We've assumed that the heir is not a widowed spouse, because especially generous rules apply in that case. Nearly all belongings and investments can be left to a spouse tax-free: The assets are deemed to be sold at their original price, so no capital gains taxe applies until the spouse sells or passes them on. What follows would apply, for example, to children inheriting their parents' estate.
Cash. The old magic folding stuff -- whether it's in the form of currency, bank deposits or guaranteed investment certificates -- can be left to a child or anyone else free of tax.
(So why don't old people simply sell everything in their lifetime and pass on a nice suitcase of $100 bills? Or simply give it to their heirs before they die? They'd still be on the hook for capital gains taxes when they sold the property or handed it over as a gift.)
Cash bequests from outside the country are also taxman-proof. If your scary old Calabrian uncle dies, and you get a nice cheque, it's a tax-free windfall.
If the bequest from abroad is big, think about setting up an offshore trust in a tax haven such as the Cayman Islands because the investment income it subsequently earns can also build up tax-free, advises Tim Cestnick, a Toronto tax consultant and author of Winning the Tax Game (Prentice Hall Canada, $19.95). You need to be looking at about $250,000 to make it worth the cost and trouble, he reckons,
The house. Just as selling your main home during the owner's lifetime attracts no capital gains tax, the principal residence gets passed on in death with no tax liability, no matter who the heir is. The beneficiary is free to turn around immediately and sell it, again with no tax hit.
Heirlooms and other belongings. This is one of the grey continents that abound in tax planning. But goods such as furniture and the family silver, provided they're not worth a fortune, can often be passed on tax-free because they're unlikely to have increased much in value.
Revenue Canada could, in theory, oblige the executor to determine the market value and then tax the estate for any capital gains that have been earned but that's unlikely, experts say.
Old people often like to pass on family treasures during their lifetime. That's usually of no concern to the tax people unless they catch a whiff of evasion. "If they thing they're being conned, they'll come after you," says Stephen Gadsden, a financial planner with Equion Financial Ltd. in Toronto and co-author of The New Heir's Guide to Managing Your Inheritance (McGraw-Hill Ryerson, $21.99).
What about Dad's spotless, loaded 1997 sedan that's had more maintenance lavished on it than an Apache attack helicopter? "The liability attached to a car is probably going to be minimal," Mr. Gadsden says, unless it's "a '69 T-bird or something that's in mint condition."
Cottages. Substantial property, however, must be evaluated properly and capital gains taxes paid on any increase in value since its purchase -- minus costs incurred for the upkeep.
Revenue Canada taxes the difference between the original cost of the cottage and its current value, Mr. Gadsden says.
RRSPs. If a spouse or common law spouse is named as beneficiary under an RRSP or registered retirement income fund, the assets pass to them with no immediate tax to be paid. And if you name a minor child or grandchild, and the child was financially dependent on you, the money can be used to purchase an annuity until the child turns 18.
But otherwise the entire amount of the RRSP and RRIF is taxable in the year of death. "Careful planning is required" when the beneficiary isn't a spouse or dependent child, says Catherine Roberts, an estate planning lawyer at Toronto law firm McMillan Binch. "In that case, the estate is responsible for settling the tax, which might result in unfairness to other beneficiaries if the issue is not properly addressed in the will."
Farms and small businesses. Up to $500,000 in capital gains can be sheltered when these are passed on. You'll need a professional lawyer and accountant because the rules are complex and the assets are often best transferred before death to ensure continuity.
How to pay less
Once the taxpayer dies, it's too late. "Unfortunately, the heir can't do anything," Mr. Gadsden says. But there are plenty of ideas you can give mom or dad right now. They include:
Buy life insurance. A policy that pays out to the heirs after death can be the nuclear bomb of estate planning -- it blows away all kinds of problems.
Life insurance payouts are tax-free and also escape probate fees because the money was never part of the estate (or didn't "fall into the estate" in lawyers' lingo). The cash can be used to cover tax bills that the estate incurs on other assets, perhaps avoiding the need to sell the family home.
The tax breaks don't apply to the life insurance industry's segregated mutual funds, Mr. Cestnick says, only to plain-vanilla death benefits.
The beneficiaries of the policy can even pay the premiums. Mr. Cestnick cites the example of a widowed parent with four children. Buying $400,000 worth of insurance on her life costs $8,000 a year, or $2,000 a child. She lives for 20 years, costing each child $40,000 in premiums in return for a $100,000 payoff at the end, which Mr. Cestnick calculates as a tax-free low-risk annual return of 8.8 per cent.
Give it away now. If a parent hands over assets as a gift while he or she is still alive, it's treated as a sale, triggering capital gains tax. But seniors can consider doing it gradually over a number of years -- they'll avoid posting a big capital gain after death, attracting tax at the top marginal rate.
For example, a senior in British Columbia with taxable income between $29,591 and $46,515 currently faces a tax rate of 29.6 per cent on capital gains. But the same senior's estate after death, if it reported income of more than $78,223, would pay a whopping 40.6 per cent of any gains.
Set up a trust. Trust law is a jungle and you'll need experts to guide you.
But one of the simplest methods is to provide for a testamentary trust in the will ("testamentary" just means it's created on death, as opposed to an "inter vivos" trust, which is set up during your lifetime.)
After death, cash-generating assets can be moved into the testamentary trust with the heirs listed as beneficiaries. The stream of income from the assets is then taxed in the hands of the trust, which pays the same rates as an individual. That means the trust can take advantage of low federal tax rates -- only 17 per cent -- on the first $29,590 of income instead of having the money taxed at the heirs' top marginal rate.
Freeze! Estate freezes, for which you'll need a tax expert, are complicated manoeuvres that fix the value of an asset and its accrued capital gains at a point in time years before death. The estate will pay taxes on gains earned up to that date and the heirs are on the hook for any subsequent gains, but only when they sell or are deemed to have sold the asset (on their own death, for example.)
Mr. Gadsden cites the example of a couple who freeze their cottage, which is already showing a $100,000 capital gain. When they die, with the cottage up another $100,000 in value, "their estate pays the tax on the first $100,000 capital gain . . . but the second $100,000 is taxed to the kids."
Cut probate costs. The basic method is to move as much as possible out of the estate, financial marketing consultant Benjamin McLean says in Guarantee Your Child's Financial Future (McGraw-Hill Ryerson, $21.99).
Assets given to heirs now aren't included in the estate later, so they don't incur those pesky probate fees, but they could count as a disposition and thus trigger capital gains tax.
Beware of cutting off your nose just to spite the probate collector, advises Malcolm Archibald, a lawyer at the Toronto firm Weir & Foulds.
For example, transferring investments and other property into joint ownership with heirs will avoid probate, but it can easily count as a partial disposition, he says. "Normally, the early triggering of the capital gains tax far outweighs the saving in probate fees."
Mr. Archibald and other experts warn that the big problem is that parents give up partial control.
"Your child's creditors could seize the asset, funds could be withdrawn from accounts or the property could be involved in a divorce settlement," Mr. McLean cautions in his book.
Mr. Archibald tells clients never to transfer anything they may need. "The child can force the disposition of the asset . . . and demand their half."
After all, growing old is difficult enough, without having to take guff from uppity kids.
Think about leaving cash-generating assets to a trust instead of giving them directly to someone who already has his or her own sources of income. Otherwise the person may simply see the taxman take a huge rakeoff.
Take the example of Ric, a British Columbian who leaves investments to his wife, Shirley, that throw off $60,000 in annual income. Shirley already makes $60,000 of her own, so the bequest bumps her up to $120,000. That leaves her with a monster tax bill of $50,300 for 1998 because more than $40,OOO of her income is vulnerable to tax at the top 54.2-per-cent rate.
But if Ric had left the $60,000 to a trust set up for Shirley, she could have split her income with it, letting both take advantage of lower tax bands. That would have produced a total tax bill of $38,870 for Shirley and the trust combined -- a big saving of $11,430.
Adapted from Tim Cestnick's Winning the Tax Game.