Over the last couple decades, many Canadians have invested in real estate, more specifically, in rental properties. As a result, their real estate holdings will constitute a substantial part of their estate therefore, their estate plan should consider how best to minimize capital gains on death and preserve their real estate investments for the next generation. Indeed, one should not overlook the tax implications involved on the death of an owner of rental properties.

Capital Gain at Death:

For estate planning purposes, taxation at death for those rental properties cannot be overlooked. The owner will be deemed to have disposed of the rental properties at the fair market value immediately before death resulting, in some instances, in a significant capital gain. The estate will have to report the capital gain on the final tax return of the deceased and pay taxes, at the marginal rate, on the resulting capital gains.

Consideration #1: does the estate have sufficient liquidity to pay the tax on the capital gain(s) arising at death?

Recapture:

If depreciation was claimed over the years, there will be recapture to be reported on the final tax return and it will be taxed as regular income. The concept of recapture plays an important role in the capital cost allowance (“CCA”) system (i.e. claiming depreciation). If the assets have not decreased in value as quickly as the CCA claimed over the years, it will result in recapture of the previously claimed CCA. In the context of estate planning involving rental properties, recapture needs to be considered.

Consideration #2: Is there recapture to be reported on the final tax return? If so, it will add additional income tax to be considered.

Example:

To illustrate the impact of the above income inclusions pertaining to a rental property, assume an individual owns a rental property that, at the time of their passing, is worth $2,000,000. They purchased the property for $750,000 and have claimed depreciation over the years they have owned it, and the undepreciated capital cost (“UCC”) is $450,000 at the time of death.  This will result in a capital gain to be reported on death of $1,250,000 (market value less cost) and recapture of $300,000 (cost less UCC).  As a result, the taxable income to be reported on the terminal return is $925,000 (assuming a 50% inclusion rate for capital gains) pertaining to the rental property.

Rental Income in the Year of Death:

The executor will also need to determine the rental income to be reported in the year of death and will first need to determine if the rental income was reported as business income or property income. This is because property income is taxed on a cash basis while business income is computed on an accrual basis. In the year of death, property income is accrued to the date of death in respect of the periodic payment of rental income.

Also, since the deceased does not own the rental properties at the end of the taxation year, no CCA is available to be claimed in the year of death. However, the estate may claim the CCA.

Consideration #3: The executor must review the previous tax returns of the deceased to properly report the rental income; property income vs business income.

Planning Options to Consider:

Tax deferral is always worth a consideration. The obvious deferral is the spousal rollover which is automatic under the tax rules. In the context of a second marriage/relationship, a testamentary spousal may be considered.

If there are several rental properties involved, moving the properties into a corporation is a consideration. For estate planning purposes, the deceased would own the shares of the corporation and would no longer own the rental properties personally, which could simplify the administration of the estate. However, moving the rental properties to the corporation requires a careful review of several other key tax concepts.

If it is determined the estate may not have immediate funds to pay for the taxes caused by death, life insurance should be considered. It would provide immediate funds available to the estate allowing the preservation of the rental properties to the next generation.

Summary:

When clients advise they own rental properties, advisors cannot overlook the different tax implications to be caused by death and how the tax will be paid.

Non-tax factors to consider:

• Are the estate’s beneficiaries to take ownership of the rental properties together?
• Is the testator “splitting” the rental properties among the estate’s beneficiaries and if so, how does one consider the fair market value (and rental income to be generated by the different rental properties) in “equalizing” the rental properties?
• Is there a non-resident beneficiary involved?