Taxation of capital property held at death

Last updated: April 2020

As most readers are aware, the Income Tax Act (the "Act") provides a variety of rules concerning the taxation of capital property held at death. This Tax Topic provides an overview of these rules.

The most common types of non-depreciable capital property are shares of a corporation, partnership interests and land.  Units in a mutual fund or segregated fund would also fall under this category.

Upon death, a taxpayer is deemed, under subsection 70(5) (a) of the Act, to have disposed of all non-depreciable capital property for proceeds equal to the fair market value immediately before death.  Any resulting capital gain must be reported on the taxpayer's income tax return for the year of death (terminal return).  One half of such gains will be added to the taxable income of the deceased individual.

An exception to this rule applies where the capital property passes to the deceased's spouse, common-law partner or spousal trust.  In this situation, the transfer takes place at the adjusted cost base (“ACB”) of the property and the capital gain is deferred until the spouse/common-law partner dies or the property is disposed of by the spouse/common-law partner or spousal trust (subsection 70(6) of the Act).  For a spousal trust to qualify for a tax-free rollover of property only the surviving spouse or common-law partner can be entitled to the income of the trust and no-one else may access the trust’s capital as long as the spouse is alive. 

If the deemed disposition on death results in a capital loss rather than a capital gain, the loss must first be used to offset the deceased's capital gains in the year of death.  If there are excess losses, the losses must then be reduced by the amount of any capital gains exemption claimed by the deceased in all previous years.  If there are any remaining capital losses, then a deduction will be permitted against other income in the year of death or in the previous year (subsection 111(2) of the Act).  This represents some relief for deceased taxpayers since capital losses are generally only permitted to be applied against capital gains and not against other types of income.

Depreciable capital property includes such assets as buildings owned for rental purposes and equipment used in an unincorporated business.  As with non-depreciable property, a tax deferral is available where such property passes to the deceased's spouse/common-law partner or spousal trust.  Otherwise, the taxpayer is deemed to have disposed of the property for proceeds equal to its fair market value immediately before death (subsection 70(5)(a) of the Act).

Consider the example of a rental property with an ACB of $100,000 (excluding the value of the land which is non-depreciable capital property), an undepreciated capital cost (“UCC”) of $80,000 and a fair market value at the time of death of $200,000.  Where no spousal rollover is available, the deemed proceeds on death will equal the fair market value of $200,000.  The amount by which the deemed proceeds exceed the ACB of $100,000 is treated as a capital gain and taxed as described previously.  The difference between the property's ACB and its UCC ($100,000 - $80,000 = $20,000) is treated as recaptured depreciation and is fully taxed in the year of death. 

If the deemed proceeds of disposition exceed the UCC but are less than the ACB, the deceased incurs recaptured depreciation but no capital gain or loss.  Where deemed proceeds of disposition are less than the UCC, a terminal loss is incurred which can be applied against other income in the year of death.

Capital gains realized in the year of death may qualify (subject to the rules discussed below concerning real property) for the capital gains exemption.  Briefly, individuals are entitled to a maximum exemption of $883,384 for the 2020 taxation year for most types of shares of qualifying small business corporations. A maximum capital gains exemption of $1,000,000 is applicable to the disposition of eligible farm or fishing property. Any portion of the exemption that was unused during a taxpayer's lifetime may be utilized in respect of capital gains realized upon death.

The availability of the capital gains exemption at a taxpayer's death leads to a number of planning opportunities:

1. The traditional spousal rollover, described previously, will not be advantageous where the deceased did not fully utilize his or her lifetime capital gains exemption before death.  In these circumstances, it may be appropriate to consider the election available under subsection 70(6.2) of the Act.  Subsection 70(6.2) allows the deceased’s personal representative to elect not to have the normal rollover rules apply where property passes to a spouse, common-law partner or spousal trust.  Thus, the personal representative may transfer sufficient property at fair market value to allow the deceased to realize the amount of capital gains necessary to maximize any unused exemption; the spouse or common-law partner receives a corresponding increase in the ACB of the property.  Any remaining property can then be transferred using the spousal rollover provisions.  With this in mind, it is important that in their Wills individuals provide executors the necessary powers to make any elections under the Act;
2. Similar results may be achieved using a "tainted" spousal trust, i.e. a trust where someone other than the spouse or common-law partner (a child, for example) has the right to capital or income during the spouse's (or common-law partner’s) lifetime.  Property passes to a tainted trust at fair market value; therefore, an individual may provide the executor with the power to transfer sufficient property to a tainted spousal trust and utilize any available capital gains exemption.  Any remaining property may then be transferred to the spouse, common-law partner or "untainted" spousal trust utilizing the spousal rollover rules; and
3. It is important to note that the lifetime capital gains exemption is normally available only to individuals.  However, under subsection 104(21.2) of the Act, the exemption is available with respect to property held in a spousal trust that is disposed during the lifetime of the spouse (or common-law partner’s).  Therefore, to the extent that the deceased spouse or common-law partner did not use up their exemption, capital gains realized in the spousal trust during his or her lifetime may be sheltered by using the spouse's (or common-law partner’s) exemption. The exemption will normally be difficult to use due to the fact that most spousal trusts prohibit the disposition of property during the life of the surviving spouse (or common-law partner).

Individuals who incur significant amounts of exempt capital gains during their lifetimes may be subject to AMT.  However, under subsection 127.55 of the Act, AMT will not apply in the year of a taxpayer's death.

In many cases, the deemed disposition rules described previously cause significant tax liabilities in the year of death.  For estates with liquidity problems, some relief is available under subsection 159(5) of the Act by filing form T2075, Election to Defer Payment of Income Tax, Under Subsection 159(5) of the Income Tax Act by a Deceased Taxpayer’s Legal Representative or Trustee.  This subsection provides that income taxes owing for the year of death may be paid in annual instalments (not exceeding ten) with interest charged at the prescribed rate from the day taxes should have been paid.  These interest charges are not incurred for the purpose of earning income and are therefore not tax deductible.

If taxes owing by a deceased individual are to be paid by instalment, acceptable security must be provided to the Minister.  This may be in the form of a charge on property owned by the deceased or by another person, or a guarantee provided by another person.

It is critical in the estate planning process to ensure that there is sufficient liquidity for the payment of taxes and other debts.  The planner's goals should include ensuring that the estate does not become subject to long term liabilities owing to CRA and avoiding the forced sale of property (perhaps under unfavourable market conditions) simply as a means of acquiring cash to pay debts. 

For these reasons, it is generally recommended that life insurance is acquired as a means of paying income tax and other liabilities which are incurred upon death.  Life insurance is the most effective means of guaranteeing that the required amount of cash will be available exactly when needed.

Where property is being passed on death from one spouse or common-law partner to another, the tax liability may be deferred until the surviving spouse’s or common-law partner’s death.  In these circumstances, individuals should consider the acquisition of insurance on the lives of both spouses or common-law partners, with proceeds payable on the second death.  This is not only a means of adapting life insurance precisely to the estate plan but may also be considerably less expensive than purchasing insurance on only one life.

The Tax, Retirement & Estate Planning Services at Manulife writes various publications on an ongoing basis. This team of accountants, lawyers and insurance professionals provides specialized information about legal issues, accounting and life insurance and their link to complex tax and estate planning solutions.

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