Experienced lawyers prepare for mediation by exploring how estate assets can be divided on a tax-efficient basis. Why? Because as a general rule, the bigger the net amount of the estate the better chance at achieving a settlement as there is more money to divide between the litigants. Woe unto the lawyer who advises a client to accept a settlement without advising the net amount to be received after deduction of tax. That is why people who specialize in tax are often consulted prior to mediation. The authors of this blog deal with the issue of how the estate may have to pay capital gains tax after death and thereby reduce the value of an estate.
On the death of a Canadian taxpayer, there is generally a deemed disposition of the taxpayer’s assets. This means that a taxpayer is deemed to have sold their property at death at its fair market value (“FMV”) and will pay capital gains tax on any increase in the FMV of the asset at the time of death in excess of the original cost to the taxpayer.
Sometimes an asset is worth more to the spouse of the deceased then to the child of a deceased. That’s because generally a deemed disposition can be delayed until the death of the surviving spouse or common-law partner if the property was indefeasibly vested with the surviving spouse within 36 months of death. So one way to resolve an impasse, when trying to divide the pie, is to have in mind that the spouse may net more by deferring the tax. It’s not just about the deferral. It’s about the opportunity to make money. While the tax eventually has to be paid, possibility at a lower rate, the taxpayer has that tax money in his/her hands longer. That means s/he can invest it. Even at a return of 5% having an additional $100,000 for ten more years may produce $50,000 of additional income. There is a value to that. For the balance of this blog let’s discuss the scenario where the taxpayer was not married or common law.
Common examples of property where income tax arises on death are stocks, bonds, private company shares and real property. Nevertheless, a taxpayer will have a deemed disposition on all properties they owned at the time of death (whether located inside or outside of Canada), including stamps, coins, works of art, jewelry, rare books, folios or manuscripts. These aforementioned items are categorized in the Canadian Income Tax Act (“ITA”) as listed personal property (“LPP”).
According to the ITA, the deemed cost of LPP purchased for below $1,000 is always $1,000. Similarly, if the proceeds of disposition is below $1,000, the proceeds is deemed to be $1,000. Thus, when a rare coin is purchased for $200, and then disposed of at $50,000, the capital gain will be $49,000. Capital gains arising from the disposition of LPP can be reduced by a taxpayer’s other capital losses. In contrast, LPP dispositions which trigger a capital loss, can only be used to reduce the capital gain from the sale of other LPP, and not from other capital properties.
One can see how not being aware of such a rule is important when a taxpayer dies, especially at a mediation. If a taxpayer left the following assets to be split equally amongst 3 children: $1,000,000 of Canadian dollar cash plus jewelry with an FMV of $500,000 and an original cost of $100,000, it is not so simple to divide the assets where each nets an FMV of $500,000. There is generally no capital gains tax on cash at death as its FMV is equal to its cost. However, the deemed disposition of jewelry will attract income tax and thus this needs to be considered at any mediation. Assuming a 50% income tax rate, the capital gains tax on the jewelry at death could be $100,000 ($400,000 capital gain at 50% capital gains rate at 50% income tax rate) which will definitely complicate matters at the mediation.
Another type of asset where a deemed disposition occurs at death are personal use assets (“PUP”). PUP would typically include cars, boats, furniture and any other assets that are for personal use. In most cases, the FMV is below the original cost and there is no income tax to pay on its disposition. These items usually decline in value over time and thus on disposition, one likely ends up with a loss. Unfortunately, gains on the disposition of PUP are taxable as capital gains but losses are not allowed to be claimed. The ITA also sets a minimum cost base on disposition and a minimum proceeds of PUP at $1,000.
Thus, if a taxpayer buys a yacht and passes away 2 months later, if the yacht increased in FMV over the 2 months, there is income tax to pay on the deemed disposition of the yacht. Alternatively, if the yacht decreased in value, the taxpayer cannot claim the loss on death.
Before we all collectively become exasperated it behooves us to remember that an experienced tax professional may have effective post-mortem estate planning techniques to defer tax and limit the cost of the estate. That is why it is very important to hire competent tax professionals to provide input on settlement strategy. They can assist in determining each asset a taxpayer owns at death and then determine the potential income tax consequence on the deemed disposition of each asset.
For those interested in this blog you may also find A tax trap in mediation – the foreign joint tenant to be of interest.