Building your legacy is a long and challenging process. We do it to improve our quality of life and provide our children with as many advantages as possible. The problem is that the taxman will not allow you to hand over your assets to the next generation without giving “the community” it’s fair share. Here is how it works in Ontario.
The day before you die, everything you own is “deemed disposed of” at fair market value, in other words, deemed sold. The resulting value is used to calculate your last taxes and probate fees. This includes shares of a private corporation, registered investments (ex RRSPs, TFSA’s, etc.), and of course, real estate, but this is by no means an exhaustive list.
Unfortunately, we can’t avoid the tax on these assets, but we can minimize it or defer it for a while. For example, you can pass your assets to your spouse at cost. Because there was no accrued value, there is no taxable event triggered. However, when an asset like real estate is transferred, assuming it is owned 100% by the deceased partner, only the asset’s present value can be transferred. Any income remains attributable to the original estate for last taxes. The same is true for corporate shares. If you own a corporation, the shares can be transferred to your Spruce; however, he or she cannot earn dividend income. If any dividends are issued, it would be attributed back to you. Again, to be clear, this is true only until your last taxes are completed. After that, the income produced by the transferred assets is now attributable to the receiving spouse.
No conversation about transferring assets/ estate planning would be complete without talking about probate. Probate is often referred to as a death tax. It’s not a tax; it’s a fee paid to the court for the process of validating a will and appointing a trustee. The trustee then deals with the estate and any tax issues that arise. To calculate probate fees, you take $5 per $1000 of the first $50,000 of a given estate value and then $15 per $1,000 after that. For quick calculations, we can use 1.5%.
Like I said before, taxes are unavoidable, but probate with some strategic planning can be reduced and, in some cases, avoided. For example, using certain investment vehicles offered by insurance companies, making sure to have at least one designated beneficiary can allow that money to bypass your estate and avoid probate.
Another useful option for those who own shares in a corporation is to use dual wills. One will would deal with probatable assets and the other with your non-probatable assets. In the event of your death, the probatable will would be provided to the court.
When planning for probate, one thing to keep in mind is not to dodge one bullet only to shoot yourself in the foot with a much bigger bullet. For example, some people will attempt to avoid probate on their principal residence by putting their kid’s names on title as owners before passing away.
Yes, this may bypass probate, but this property is likely not the principal residence for the children then, thus neutralizing any principal residence tax exemption the estate may have enjoyed. When the house is deemed sold, the assessed value would be taxed as income at the highest tax bracket, 53.5%, rather than merely paying the probate fees of 1.5%, not to mention the transfer of title would likely trigger land transfer tax as well.
Gifting assets before you die is an option, but you are deemed to have sold the asset at fair market value even then.
It’s a fairly common scenario where, after years of accumulating assets, parents eventually want to give these assets to their children, like real estate. Unfortunately, as I mentioned earlier, you cannot just give assets away. There is going to be some tax to be paid. Remember, assets gifted before death are deemed to be sold at fair market value to whomever they have been given, even though no cash has changed hands. Not only that, often, whoever received the asset likely doesn’t have the money on hand to pay the tax upon transfer either and has to sell the asset to pay the resulting tax.
Even if you inherit the asset, a deemed disposition has occurred. The estate would pay the tax, and then the asset would be distributed to the beneficiaries. Oh, and if you think you can get around this problem by just selling the asset to your intended beneficiary for $1.00, think again. What happens in scenarios like this is the individual that gave the property away or sold it is deemed to sell it at fair market value and pays tax based on fair market value. The individual who received the asset has a cost base of whatever they paid for the asset (in this case, $1), so when they eventually sell the asset, they will pay Capital gains tax on the asset’s full value!
So, is there a solution? Well, there are a few options.
Option one, report the deemed disposition, pay the taxes on the accrued gains and then take back a loan for the money that would otherwise have been paid to the individual who made the gift. This simply transfers the asset to the intended recipient. However, in certain circumstances, the loan can be forgiven, and no money has to change hands.
Option number two, sell the asset to a third party, pay the taxes and give the after-tax proceeds to the beneficiaries and they can do as they please with the cash. Cash gifts are seen as after-tax dollars, and therefore no further tax need be paid.
Option number three is an Estate Freeze. The purpose of an estate freeze is to transfer the future increase in the value of an asset to the next generation. Generally, the asset is in the form of shares in a Corporation. So, in the case of real estate, the properties in question can be rolled into a corporation first.
The transferor retains the corporation’s current value and defers the capital gains to the time of actual or deemed disposition. An estate freeze allows the next generation to enjoy future growth benefits while resulting in a lower capital gain on the deemed disposition when the transferor dies.
Option number four is to buy life insurance. This, in my opinion, is the simplest way to deal with the tax problem, but I’m biased given we sell this stuff. By using life insurance, we are putting an asset in place that will pay any taxes on a deemed disposition one day. The type of life insurance used in this strategy is either whole life insurance or universal life insurance. The reasons being, among other things, that these two types of policies are more likely to be around when needed. There is a third type of life insurance called term life insurance that is a no frills version better suited for temporary needs like insuring debts or making sure there is money to raise a family if one partner dies. Generally speaking, term policies expire at around age 75.
Whole life and Universal policies generally have a cash value that grows tax differed similar to an RRSP. The difference being, upon the life insured’s death, everything in a life insurance policy is paid out tax-free, unlike an RRSP where 100% of the proceeds are taxable as income upon death.
There are other benefits when using life insurance, such as the fact that you can buy a policy that you only have to pay for 10 or 20 years; however, the policy’s growth continues to increase as long as the policy is in force.
After seventeen years as an advisor, I can tell you that life insurance policies used to minimize the effects of taxes and probate on a person’s estate have substantial premiums attached to them. However, those premiums’ total cost has generally been a small fraction of the taxes that would have otherwise been paid without life insurance—making life insurance a very attractive option if you are looking to maximize what you leave as a legacy.
If you would like to know more about these strategies pertaining to your own estate planning or to receive a quote for life insurance, please call me at 905-881-7726 ext 235.