What to know about death and taxes

There’s no so-called death tax in Canada. But, while the government doesn’t levy special duties or taxes upon death, income taxes in the year of death are significant and inescapable.

And with the deceased having already moved on, it’s the executor who’s left to figure it all out.

In order to develop or administer a comprehensive, tax-efficient estate plan, you need to understand the basic rules for deceased taxpayers and their estates.

Death of a Taxpayer

Let’s start with the period up to the date of death, including taxation in the year of death. Two rules govern taxation in the year of death. First, income earned and accrued from January 1 to the date of death is reportable on the final (terminal) T1 tax return. All income actually received by the deceased must also be reported in the terminal T1 return.

This includes standard items such as investment income and employment income. All accrued income amounts must also be included on a per-diem basis. The fair market value of all RRSPs/RRIFs also must be included.

Second, a deceased taxpayer is considered to have disposed of any capital property immediately prior to death for fair market value. Capital gains and losses must also be reported on the terminal T1.

For most of us, our final tax bill will be our highest by far and the disposition rules provide the backdrop for most estate-tax planning. Luckily, there are provisions in the rules, such as rollovers, exemptions and elections, which soften the blow.

Rollovers, Exemptions, Elections

A common rollover involves transferring assets to a surviving spouse. The rollover is available for capital property and RRSPs/RRIFs.

It allows such assets to be transferred to a surviving spouse (by a variety of methods) with no immediate tax consequences. Instead, the usual deemed disposition will be deferred until the death of the surviving spouse.

For income-tax purposes, spouse may include legally married, common-law and same-sex couples. Other possible rollovers include family farms to a child or grandchild and RRSPs to a dependent minor child or grandchild.

The most significant exemption for most taxpayers applies to the principal residence. Other possible elections include filing additional tax returns in the year of death and splitting certain types of income.

What happens to income earned and/or payable after the date of death? Tax rules require all income be captured somewhere. As a result, income earned after death must be reported in either a trust return or the beneficiary’s personal return.

Even if the deceased didn’t leave a will, there is generally post-death income and, more often than not, the estate will need to prepare and file at least one T3 trust return. Post-death income may include investment income or income from rental properties.

Perhaps the most common example of post-death income is the Canadian Pension Plan (CPP) death benefit, which is paid to heirs. This benefit must be reported by the recipient and can’t appear on the deceased’s terminal T1 return.

How to Implement

The job of implementing the plan established in the will—and addressing the tax consequences of the testator’s death—falls to the executor. In many cases, tax work accounts for a significant portion of an executor’s work.

Executors must complete and file the year-of-death return. They’re also responsible for any T3 and unfiled returns for prior years. If executors don’t meet the filing deadlines, they risk interest and penalties.

Executors are also expected to minimize the taxes payable, subject to the terms of the will and general anti-avoidance provisions. This means they should be aware of, and take advantage of, all available post-mortem planning opportunities. This may involve deciding to file certain optional year-of death returns and considering all available elections and exemptions, including the most judicious use of the principal-residence exemption.

Executors could incur personal liability if they fail to carry out these responsibilities, so you should obtain professional advice and learn about the protection afforded by a Clearance Certificate.

Elaine Blades and Scott Cummings