Death of a Taxpayer – Part Two

Nine years ago, MoneySaver published Brian’s four-part article dealing with the death of a taxpayer. In this edition, we continue the running of an updated version of the article.

Lana, Editor-in-Chief

This is the second article dealing with the death of a taxpayer. Part one presented the income tax implications of death, part three will focus on the mandatory and optional separate personal income tax returns that can be filed for a deceased taxpayer and part four highlights strategies to minimize the income tax due on death.

This article deals with special income tax rules impacting the payment of a deceased’s income tax liability as well as capital loss utilization in the year of death.

Paying The Deceased's Income Tax Liability

The first part of this article dealt with the deemed sale—or deemed disposition—of assets on death. On death, a taxpayer is considered to have sold all their assets (not held in a Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF) or Tax-Free Savings Account (TFSA) at market value. The accrued capital gains—and perhaps recapture if a rental property is owned—are triggered and included in the deceased’s taxable income. In addition, on death, any RRSPs and RRIFs of the deceased are deregistered and the value is also included in the deceased’s taxable income. Finally, the deceased’s regular income earned in the year of death (employment, self-employment, pension, and investment income, etc.) is included in taxable income for the year of death.

It is easy to see that the deceased may have a very substantial taxable income in the year of death and a significant income tax liability. When there is a surviving spouse (which, for income tax, includes a common-law spouse) the income tax can be deferred where assets, RRSPs and RRIFs are passed to the spouse. However, when there is no surviving spouse the income tax is due by April 30th (June 15th if the deceased was self-employed) of the year following the year of death or six months after death—whichever is later.

This can be particularly onerous if it is necessary to sell assets of the deceased to obtain cash to pay the income tax bill. Some assets, such as a rental property or a family home or cottage cannot be liquidated immediately. Furthermore, the timing may not be appropriate if there is a “depressed market”.

With respect to the income tax that arises due to the deemed sale of assets at death, an income tax election can be made by the estate trustee to pay this income tax in ten equal annual consecutive instalments. The election is made using income tax form T2075 and security must be provided to Canada Revenue Agency (CRA). CRA will charge interest on the outstanding income tax debt. The first instalment is to be made by the date when the full income tax payment was originally due.

Personal Income Tax Instalments; Prior Year Income Tax Liabilities

Where the deceased was paying quarterly personal income tax instalments it is not necessary for the instalments to continue after death. However, any income tax instalments due before death, but not paid, are still required to be made. The income tax liability and unfiled personal income tax returns of the deceased for a previous year remain due as of the regular due date.

Revisiting The Deemed Sale Of Assets At Death

As noted, where an asset that is not held in an RRSP, RRIF or TFSA of the deceased is passed to a surviving spouse, the deceased taxpayer does not incur an income tax liability in respect of any accrued capital gain or recapture at the time of death. This is an automatic income tax provision with the result being that the income tax bill in respect of an appreciated value of the asset is deferred until the later of the surviving spouse selling the asset or dying while owning the asset. The mechanics of the provision are that the deceased spouse is deemed to have sold the asset to the surviving spouse at a selling price equal to the adjusted cost base (tax cost) of the asset. Therefore, no capital gain or recapture is recognized on the death of the first spouse.

However, there are instances where it is best that the automatic income tax provision does not apply. For example, if the deceased has realized capital losses in the year of death or has unused capital losses being carried forward from previous years. These losses cannot be passed to a surviving spouse (or any beneficiary). Here, it is best to elect out of the automatic income tax provision to permit an accrued capital gain to be realized which would be sheltered from income tax by the capital losses of the deceased. The surviving spouse’s resulting tax cost of the asset received would be equal to the market value of the asset on the first spouse’s date of death. In other words, by making use of deceased’s capital losses, the tax cost of the asset in the surviving spouse’s hands has been “bumped” up (increased) to market value at the time of death of the first spouse.

Another case, where it may be preferred to elect out of the automatic income tax provision, is where the deceased, at the time of death, owns shares of a small business corporation that qualify for the $892,218 (2021) capital gains exemption or owns a farm or fishing property that qualifies for the $1,000,000 capital gains exemption. If the deceased’s available capital gains exemption is not used on death it is lost forever. Therefore, it is again best to trigger the gain, make use of the exemption and the surviving spouse will have a higher tax cost in respect of the small business corporation shares or farm or fishing property received.

Where a death occurs early in the year, the taxpayer’s taxable income may be quite low as only the income earned before death is reported on the final personal income tax return. An income tax planning idea here is to ensure some capital gains are considered realized to ensure that all the applicable personal income tax credits are utilized. These income tax credits are not pro-rated for the time in the year the taxpayer was alive. (Part three of this article deals with the claiming, and potentially multiplying, the personal income tax credits available to a deceased taxpayer.)

A taxpayer can incur significant medical expenses in the year of death. Again, it may be best that the taxpayer report sufficient taxable income to create an income tax liability that can be sheltered from income tax by the medical expense tax credit.

Finally, the deceased may have an Alternative Minimum Tax (AMT) carry-forward amount—a potential income tax credit. In this case, the income tax plan is to have the deceased’s taxable income high enough to create an income tax liability that can be offset by the AMT carry-forward amount. (The income tax provisions provide that the deceased cannot have an AMT liability in the year of the death.)

Capital Loss Utilization Without Capital Gains

Generally, capital losses may be claimed to only reduce capital gains that are subject to income tax. Where a taxpayer, deceased or not, incurs a capital loss in a year where there are no capital gains (realized and/or deemed to be realized) in the same year, the capital loss can be applied to capital gains reported as far back as three years. If the full capital loss cannot be fully utilized in the current or three past years, the taxpayer, if alive, can carry the capital loss forward to shelter future capital gains. However, if it were not for a special income tax rule, the deceased taxpayer’s unused capital losses would disappear.

The special income tax rule permits the deceased, in computing taxable income in the year of death, to deduct the unused net capital losses (which are 50% of the actual capital losses) against other types of income: employment, self-employment, pension and investment income and including the taxable income inclusion resulting from RRSPs and RRIFs being deregistered on death.

The amount of capital losses that can be deducted in the year of death is reduced where the taxpayer has made use of the capital gains exemption. Use of the capital gains exemption goes back to 1985 and many taxpayers made use of the exemption by filing a capital gain election with their 1994 tax return as part of the phase-out of the $100,000 capital gains exemption. CRA can provide the history of a taxpayer’s use of the capital gains exemption.

Brian J. Quinlan, CPA, CA, CFP, TEP

Campbell Lawless LLP,Chartered Professional Accountants

bjq@clcpa.ca