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Funding Taxes on Death
- Rental Properties
A liability for taxes and other fees (e.g., probate fees) on some or all of your
registered and other
assets at death is generally inevitable. In fact, the amount of this liability could well
be the highest tax liability you (in this case your estate) will ever have faced! Any
taxes and fees payable by the estate, as well as any debt owing by the estate, will
diminish its value – in some cases the impact will be significant. Equally important
is the fact that your executors may have to liquidate assets in order to pay the taxes and
other liabilities that are due – assets that you had intended would go to your
beneficiaries. |
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There are a number of reasons for the high
tax liability at the time of death. As may be expected, the final or terminal tax return
must include all regular income that the deceased had received in the year of death up
until the date of his or her death. This includes wages, interest and dividend income. The
full balance of registered assets (RPPs, DPSPs, RRSPs or RRIFs (or equivalent locked-in
plans)) must generally also be reported on this same final return, unless the beneficiary
is a spouse, financially dependent minor child or financially dependent mentally or
physically incapacitated child. Finally, all capital property is deemed disposed of
immediately before the deceased’s death and the resulting capital gains and losses
must be reported on the deceased’s final return.
For example, assume that you and your spouse are both 65 and that you own a large rental
property currently worth $530,000 ($130,000 for land and $400,000 for the building). You
bought the property a number of years ago for $150,000 ($50,000 for land and $100,000 for
the building). The building has been depreciated at 4% per year and its current
undepreciated capital cost is $60,000. The land and the building are expected to grow at
3% per year. Your wills leave everything to the surviving spouse.
Today, your estate is worth $530,000 and there will be taxes and probate fees of
approximately
$123,000 if you and your spouse pass away. However, your estate will have grown to
approximately $950,000 when you and your spouse are 85 (your life expectancy) and the tax
and probate fee liability will have grown to approximately $240,000. The tax liability
includes the capital gain on the land and building as well as the recaptured depreciation
on the building.
How to satisfy the tax and other liabilities due upon your death - Four Options
A number of options may be considered in deciding how the estate will meet these
obligations.
1. Selling the Assets After Your Death: Your estate could sell an asset
or assets to pay the taxes and other liabilities. However, many of these assets may have a
significant sentimental value or may have been family assets for a number of generations;
therefore, this option may not be an ideal one. For example, would your family really want
to sell the cottage that has been in the family for generations in order to pay the taxes
owing on it? Also, it may be difficult to realize the best value for an asset at the time
these amounts are due. This may be because values are depressed due to current economic
conditions, or because the asset is not liquid (e.g., is an asset with a limited resale
market).
2. Saving Up for the Taxes During Your Lifetime: The second method is
for you to start saving now for the taxes and other liabilities needed to be paid upon
your death. It is almost like a “sinking fund” approach. By putting $13,880 away
each year for the next 10 years, there will be enough cash to pay the taxes, assuming a
pre-tax rate of return of 7%. Again, this option may not be an ideal solution, or a
practical one. Most families need money for on-going commitments such as paying down the
mortgage on the home, providing for their children’s education or setting aside money
for their retirement years. In any event, it is impossible to predict exactly the date of
one’s death; therefore, the death may occur before these funds have been accumulated.
Furthermore, this method may not be tax effective, nor may the funds be secure from
creditor claims.
3. Borrowing the Funds: Another option is to have your estate borrow the
funds after your death to pay the taxes and other liabilities. Assuming a 10-year loan at
an 8% interest rate, your estate would have to pay $36,194 each year to pay these amounts.
This method actually increases your debt rather than reduces it due to the interest
charges. In the end, assets will still have to be liquidated (unless the estate has a
steady income or cash flow) with which to meet the borrowing costs and make the necessary
repayments of capital. The estate may experience delays in distributing assets to the
beneficiaries, as the estate’s assets may need to be pledged as collateral to the
lending institution. Again, this method is not tax effective where the estate cannot
deduct the costs of borrowing.
4. Acquiring Life Insurance: Fortunately there is a better way. Life
insurance is generally the most cost-effective way to pay the taxes and other liabilities.
For literally pennies in premiums, you can pay dollars in taxes! In your case, by
purchasing an insurance policy with a face amount of $123,057 today, you will be able to
satisfy these liabilities at the time of your death.
Why Life Insurance is Your Best Option
Life insurance is attractive from a tax perspective because of two key contributing
factors, each of
which is discussed below:
? ?Tax-deferred income/growth within the policy
? ?Tax-free nature of any death benefit.
Tax-deferred income/growth within an exempt policy
Sections 148 and 12.2 of the Income Tax Act (Canada) (“ITA”) allow you to use a
Universal Life
insurance policy to build up a tax-deferred fund. The investment income that is earned
each year within the policy is not subject to tax, provided certain ITA-imposed limits are
not exceeded. (However, tax may be payable if the contract is disposed of either in whole
or in part.) When this accumulated investment income is paid out to the beneficiaries as
part of a death benefit, this tax-deferred amount becomes a tax-free amount!
Tax-free nature of any death benefit
Life insurance proceeds are received tax-free. This means that you are able to use
tax-free dollars to pay government taxes. That’s why a premium of $6,741 per year for
10 years provides $242,866 of death benefit by the time you are 85 years of age.
Thus, by using life insurance to satisfy your estate’s liability for income taxes,
any probate and other fees, as well as debts that are payable upon your death, both you
and your beneficiaries have the comfort and security of knowing that these taxes and other
amounts will be paid. You ensure your family (or other beneficiaries) of a bequest and/or
inheritance, not a headache! Furthermore, the estate you worked so hard to build goes to
the intended beneficiaries, and not to pay a significant amount of income taxes and other
liabilities.
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