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Taxation at Death: Using Rollovers to Defer Taxes

Rollovers

According to the Canadian Income Tax Act there are two circumstances under which death need not bring forth a deemed realization of non-depreciable capital property or depreciable capital property:

1) Outright transfer to a spouse, or transfer to a qualifying spousal trust; and

2) Intergenerational transfer of farm property.

In these examples the transferee would acquire the property at the deceased’s tax cost. It allows a deferral, but not an elimination, of the capital gain (and recaptured depreciation) until an actual or deemed realization by the transferee takes place. This is preferred because taxes are deferred and can be properly planned for. With respect to RRSPs, outright transfers to spouses also can avoid a deemed disposition.

Transfers

Should the taxpayer be resident in Canada immediately before his or her death, and non-depreciable capital property or depreciable capital property after the death “and as a consequence thereof” had been transferred to his or her spouse who was resident in Canada immediately before the death, the deemed realization rule would not apply. Instead there would be a “rollover” to the surviving spouse (ITA, S. 70(6)) and provided also that the property was “indefeasibly vested” in the surviving spouse within 36 months of death; the deemed realization rule would not apply but instead there would be a “rollover” to the surviving spouse (ITA, s. 70(6)). There is no election to bring about this result, it is automatic because the deceased left a spouse.

This rollover rule permits the death of the first spouse to constitute a non-taxable event. As the surviving spouse acquires the property at the deceased’s tax cost, and eventually realizes a capital gain spanning the period of ownership of both the deceased and the surviving spouse, the property is brought into income when the surviving spouse either disposes of the property by sale or is deemed to dispose of it by death.

Evolution of the legal meaning of the word “spouse” is worthy of some examination here. There was a time where “spouse” in the ITA only referred to a married spouse. It has since been extended to include common-law spouses for certain limited purposes, and then further extended as of January 1, 1993 to include common-law spouses for all purposes of the ITA.

There is a defined meaning of the phrase “as a consequence thereof” given in the ITA, s. 248(8) and CRA’s Interpretation Bulletin IT-305R4 “Testamentary Spouse Trusts”, which includes a transfer resulting from intestacy. Also included, a transfer resulting from a “disclaimer, release or surrender” executed by a beneficiary other than the spouse. It is a document that has as its key element no direction as to the person to benefit thereby, so that the interest is essentially “given back to the estate.” Normally, CRA extends rollover treatment to a transfer of capital property that takes place pursuant to a court order, pertaining to either dependants’ relief or family property. As regards the concept of “indefeasibly vested”, it means that the spouse acquire an absolute ownership interest that cannot be defeated by any future event.

Indefeasible vesting is often inadvertently precluded in agreements made by a deceased prior to his or her death thus preventing access to the rollover. When a deceased person has bound his estate to sell property to a third party as a result of his or her death (as is commonly the case in shareholders’ agreements), no spousal rollover can be obtained. If, however, the deceased has only granted an option, then it becomes a question of fact whether the property has been transferred to the spouse who subsequently sells the property, whether the property was sold by the estate, or whether the option was in fact exercised at all. The preservation of the rollover should be a primary decision in drafting contracts binding on a taxpayer’s estate.

As regards rollovers to spousal trusts, it is not any trust to which the rollover applies; instead, the trust must have two key parameters (ITA, s. 70(6)(b)) allowing it to follow under the category commonly known as a “qualifying spousal trust”.

Firstly, the spouse should be entitled to receive all of the income of the trust that arises before the spouse’s death. Secondly, no person except the spouse may obtain the use of any of the income or capital of the trust during the spouse’s lifetime. Such conditions would not be fulfilled if, for example, the terms of the spousal trust provide that should the surviving spouse remarry, the trust property would then vest into a third party. A remarriage stipulation like this would prevent the trust from being a qualifying spousal trust.

It is not unusual for a testator to establish a testamentary spousal trust so as to control the ultimate distribution of the trust capital. In that event, non-tax objectives (such as the desire to permit access to capital to persons other than the spouse during the spouse’s lifetime) could be at odds with the required parameters of a qualifying spousal trust that the testator would have to adhere to in order to obtain a rollover. As a way out, a testator could create a qualifying spousal trust as well as a “tainted” spousal trust, and would give his or her personal representative the discretion to determine which assets are to be allocated to which trust. This procedure is accepted by the CRA (Interpretation Bulletin IT-305R4 “Testamentary Spouse Trusts”, at para. 8). However, it is not clear whether or not the CRA permits the discretion to establish the relative values of the trusts to be delegated to the personal representative.

Learn more about Taxation at Death herehere and here.

Don’t do anything before fully understanding your rights and obligations.  contact the lawyers at Levy Zavet PC (Levy Zavet) in Toronto, Ontario for more information about estate planning, estate administration and tax law.

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