1. Taxation on Death the Basics
Before discussing estate planning options to minimize taxes, it is important to understand the types of taxes that may arise as a consequence of an individual’s death, or on a transfer of the property following death, on personally-held real estate. These taxes include capital gains taxes, estate administration tax (commonly known as “probate fees”), and land transfer tax.
2. Capital Gains Taxation
Subject to certain exceptions, discussed in more detail below, the Income Tax Act (the “ITA”) provides that a taxpayer is deemed to have disposed of his or her capital property for fair market value immediately prior to death. As a result of this deemed disposition, if the fair market value of the property at death is higher than the adjusted cost base of the property (“ACB”), a capital gain equal to the difference between the fair market value at the date of death and the ACB of the property will result. One half of this capital gain must be included as income in the taxpayer’s terminal return, and will be taxed at the applicable marginal rate (for simplicity, the tax arising from the capital gain is referred to herein as the “capital gains tax”).
By way of example, imagine an individual purchases a cottage property for $150,000. She passes away several years later, at which point the fair market value of the cottage property has increased to $450,000. The deceased is deemed to have disposed of the cottage property immediately before her death at fair market value; accordingly, there is a $300,000 capital gain, of which one-half, or $150,000, is taxable and is included on the deceased’s terminal return. Where property is held as joint tenants or tenants-in-common, the deceased individual is deemed to have disposed of only his or her proportionate share of the property. In the above example, if the individual owned the property as tenants-in-common with two of her siblings, each with a 1/3 interest in the property, her ACB would be $50,000, and the fair market value of her share at death would be $150,000, giving rise to a taxable capital gain of $100,000, of which $50,000 is taxable. The tax liability arising from the capital gain is payable by the deceased’s estate. If a property is transferred shortly after death, the adjusted cost base to the beneficiary will likely be equal to that of the fair market value at the date of the deceased’s death. On occasion, however, the fair market value of the property will rise between the deceased’s date of death and the date the property is actually transferred to the beneficiary, giving rise to an additional taxable capital gain to the estate equal to one-half of the difference between the fair market value at the date of death, and the fair market value at the date of transfer. For many individuals, real property represents their most substantial asset, and can give rise to a significant taxable capital gain. The ITA includes two important relief provisions to facilitate the minimization and/or deferral of the taxes arising from capital gains on this important asset: the principal residence exemption, and the spousal “rollover” provision.
Principal Residence Exemption
Section 40(2)(b) of the ITA sets out an exemption from capital gains taxes for an individual’s primary residence (the “Primary Residence Exemption” or “PRE”). In simple terms, the PRE is a formula that allows an individual to shield a property from capital gains tax during the year or years in which the property is designated as a person’s “principal residence”.
(1 + number of years designated x gain)/number of years owned = exemption amount
An individual can apply the designation of “principal residence” to a real property in the year of its disposition for any one or more of the years it was held prior to being disposed of. For a person to be able to designate a property (whether inside or outside of Canada) as his or her principal residence, the person must be a Canadian resident during the years claimed, the property must be capital property, and the property must be a “housing unit” that was “ordinarily inhabited” by the person. In addition, where a person is the beneficial owner (as opposed to legal owner) of a property, he or she will qualify for the PRE. In the most common scenario, an individual owns a single property, which is his or her family home. After disposing of the home, the individual declares the home as his or her primary residence for the entirety of the time it was held, and, by application of the formula, no capital gains taxes are payable. This same treatment applies on death: while there is a deemed disposition of capital property at the date of death, the executor can, in the terminal return, designate a real property as the person’s principal residence for the years it was held while they were alive, and thus no capital gains taxes will be payable on the property at death.
The primary residence does not have to be a person’s home; a person could designate their cottage or chalet, for example, as their primary residence. The Canada Revenue Agency (the “CRA”) has confirmed that a property that is occupied occasionally throughout the year, or seasonally, may be considered “ordinarily inhabited”. Accordingly, where an individual owns more than one property, it is advisable to designate that property with the greatest annual increase in fair market value as the principal residence in order to minimize the taxable capital gains payable on death. In addition, while only one property can be designated as an individual’s primary residence in a given year, different properties can be designated as the principal residence in different years, in order to maximize the capital gains exemption. Of note, however, is that spouses or common-law partners cannot designate more than one residence per year during the time that they are a family unit – i.e. each person does not get his or her own designation.
The payment of capital gains taxes may be deferred, such that they are not included in the deceased’s terminal return or payable by the deceased’s estate, if the property which gives rise to the gain is transferred to the deceased’s spouse after death, or is held in a spousal trust for the benefit of the spouse. The property is deemed to be transferred (or “rolled”) to the spouse at its ACB. Capital gains will arise only on the death of the second spouse, or when that spouse otherwise disposes of the property. This rollover is particularly important for secondary properties, such as cottages or chalets, which may not be shielded by the PRE. Of note, an individual cannot transfer a share in a property that is held as joint tenants with a third-party to their spouse, as the property will automatically pass to the surviving joint tenant.
3. Estate Administration Tax ("Probate Fees")
The Certificate of Appointment of Estate Trustee with a Will (commonly referred to as “probate” and referred to herein as the “Certificate”) is a document issued by the Superior Court which confirms that the Will of the deceased can be relied upon as the valid last testamentary instrument of the deceased. While an executor’s authority derives from the Will, many third party institutions, including the land registry office, require the Certificate for the executor to be able to deal with the assets held with the third-party.
At the time the application for the Certificate is submitted, Estate Administration Tax (more commonly known as “probate fees” and referred to herein as “EAT”), is payable on all of the assets governed by the Will for which the Certificate is being applied. EAT is currently levied at the following rates:
· 0% on the first $1,000 of estate value; plus
· 0.5% on the value of the estate above $1,000 up to and including $50,000; plus
· 1.5% on the value of the estate above $50,000.
Of note, EAT is not payable on real property held as joint tenants, as the property passes directly to the surviving tenant and does not pass by way of the deceased tenant’s Will. EAT is also not payable on the value of real property situate outside of Ontario. EAT can quickly add up to a substantial amount. As a result, several estate planning strategies have been developed to minimize the EAT payable following death, as described later in this paper.
4. Land Transfer Tax
Land Transfer Tax (“LTT”) is payable on the “value of consideration” when real property is conveyed. In Ontario, land transfer tax on a single family residence is payable at the following rates:
· 0.5% on the first $55,000 of real property value; plus
· 1.0% on the value of the real property above $55,000 up to and including $250,000; plus
· 1.5% on the value of the real property above $250,000 up to and including $400,000; plus
· 2.0% on the value of the real property above $400,000.
The City of Toronto also charges its own Land Transfer Tax (referred to as “MLTT”). Land Transfer Tax is nil when real property is gifted. Land Transfer Tax is also not payable on the transmission of the property to the executor for the purpose of administering the estate (though may be payable once the executor disposes of the property in the process of administering the estate).
II. Estate Planning Strategies
There are various estate-planning strategies an individual can employ to minimize or defer the various forms of tax that can arise on the individual’s death. Some strategies are straightforward (gifting the property by Will), and others are more complex (the use of a nominee corporation or a trust structure). It is important in undertaking any strategy to consider the impact on all taxes. It is possible, for example, to attempt to minimize EAT by transferring ownership of a real property, but in doing so one may inadvertently incur significant capital gains taxes or LTT at the time of transfer, potentially offsetting the reduction in EAT. In addition, individuals must balance the tax-minimization effects of their proposed estate plan with other potential effects. For example, if full or partial ownership of a property is transferred to another person or to a trust to avoid EAT, the original owner of the property may lose control of the property, and the property may be subject to the claims of the others’ creditors.
1. Gift by Will
Perhaps the most straightforward option to minimize taxes on real property at death is to gift the property by Will to one or more individuals. As set out above, where real property is gifted to someone, no LTT is payable on the transfer, as there is no consideration paid for the property. In addition, if the property is the deceased’s principal residence, no capital gains will arise on the deceased’s death as a result of the PRE. If the property is not the deceased’s principal residence but is gifted to a spouse, capital gains will be deferred until the spouse disposes of the property, as a result of the spousal rollover (discussed in more detail below).
Of note, if choosing to gift a non-principal residence to anyone other than a spouse, capital gains taxes will be payable by the estate, not the recipient of the property. It is possible, then, that if there are several beneficiaries of the estate but only one is to receive the real property, the other beneficiaries will bear the burden of the capital gains taxes without receiving the benefit of the real property. While gifting the property is the most straightforward option to deal with the property, EAT will be payable on the full value of the Ontario real property (with limited exceptions through the use of dual Wills, as set out below). Like capital gains taxes, EAT is payable by the estate, not the recipient of the property, and so could create a similar unfairness in the distribution of the estate.
2. Inter Vivos Transfer
Another option to minimize or defer taxes at death on real property is to transfer ownership of the property prior to death. Property may be transferred outright, or into joint tenancy with another person or persons, so that the property simply transfers to the survivor on the death of the transferor, without incurring EAT.
3. Transfer to a Spouse
Where property is owned as joint tenants with a spouse, on the death of one spouse, the property simply passes by right of survivorship to the surviving spouse, without any tax consequences. No capital gains taxes or LTT are payable at the time of the transfer to joint tenancy with a spouse, nor do taxable capital gains arise as a result of the death of the deceased spouse. In addition, EAT is not payable on the property, because it does not form part of the property disposed of by the deceased spouse’s Will.
There may be reasons why an individual does not wish to hold property as joint tenants with his or her spouse, including creditor protection, or a desire to keep assets separate, perhaps in circumstances where there are children from a previous marriage. For these people, a spousal trust may be an effective option. However, for many people, holding real property as joint tenants with a spouse is a simple, tax-effective estate planning strategy. Sometimes an individual will transfer a property outright to a spouse on the assumption that the transferor spouse will predecease the recipient spouse. However, such a strategy is not without risk: while no capital gains taxes or LTT are payable on such a transfer, if the recipient spouse predeceases the transferor spouse, EAT will be payable on the property following the death of the recipient spouse, notwithstanding that the transferor spouse is still alive.
4. Transfer to a Third Party - Outright Joint Ownership
Sometimes a person will transfer real property either outright to, or into joint tenancy with, a person other than a spouse in an attempt to minimize EAT payable after death. Most commonly, a parent will transfer his or her real property outright to, or into joint tenancy with, an adult child or children. There are significant risks associated with holding a property in joint tenancy with another person. Property held as joint tenants with another person is subject to claims by the individual’s creditors. In addition, if the transfer is not properly documented with a deed of gift including specific language referencing provisions of the Family Law Act, should the joint tenant and his or her spouse separate, the property will form part of that person’s net family property and be subject to an equalization claim.
Putting property into joint tenancy with another person also grants that person significant control over what happens to the property - the property cannot be sold or otherwise disposed of without that person’s consent. In addition to all of the risks outlined above, the transfer of property into joint tenancy with an adult child may not even successfully reduce the EAT payable on the property. The 2007 SCC decision in Pecore v Pecore found that where a parent gratuitously transfers property to an adult child, there is a rebuttable presumption of resulting trust in favour of the parent. If the presumption cannot be rebutted, i.e. there is insufficient documentation to show that the parent truly meant for the transfer of property to be a gift to the adult child, the property will be subject to the terms of the parent’s Will, and will form part of the parent’s estate for the purpose of calculating EAT payable.
For both an outright transfer to a child and a transfer into joint tenancy with a child, provided there is no consideration passing between the parties, LTT will be nil. Capital gains taxes, however, will arise on the portion of the property that is transferred to the child, if the property is not the parent’s principal residence (it will otherwise be protected by the PRE). If the child already has a principal residence, the parent’s property, or the portion gifted to the child, will no longer qualify for the PRE. The transfer of the property crystallizes the ACB of the property for the child at the fair market value at the date of the transfer. As a result, if a parent transfers his or her principal residence during his or her lifetime to a child in an attempt to circumvent EAT, the resulting capital gains at the time the child disposes of the property could be substantially higher than would be the case if the parent owned the principal residence until death, exempted the entirety of the capital gain until death by way of PRE, and then transferred the home.
5. Minimization of EAT
There are two circumstances specific to Ontario real property under which EAT may not be payable by an estate: where the disposition of the property following death is the “first dealing” of the property following the property’s conversion from the Registry System into Land Titles, and where legal title to the property is held by a nominee corporation.
First Dealing After Conversion
Starting in the 1700s, real property held in Ontario was recorded in the land Registry System. A second system, Land Titles, was later introduced. Beginning in the 1980s, Ontario began to convert properties held in the Registry System to Land Titles. This conversion has given rise to a situation in which a Certificate is not required to deal with real property: if the property was previously held in Land Titles, and was converted to Land Titles Conversion Qualified (“LTCQ”), and the transfer of the property following the death of the property owner is the “first dealing” in connection with the property since its conversion to LTCQ, a Certificate is not required to deal with the property. “First dealing” means the property has not been transferred, mortgaged, or otherwise encumbered since its conversion to LTCQ. Where a person’s real property meets the first dealing exemption, and the person has no other assets that require a Certificate to be dealt with, only one Will is required to deal with the person’s assets in a tax-efficient manner: no application for a Certificate will be required, and no EAT will be payable. Where a person’s real property meets the first dealing exemption, but the person has other assets that require a Certificate, in the absence of two Wills, the full value of the real property must be included in the assets governed by the Will, notwithstanding that a Certificate is not required to deal with the property. EAT will be payable on the value of the real property. By using dual Wills, a strategy discussed in greater detail below, the testator can effectively separate the real property from the remainder of the assets requiring a Certificate to be dealt with, and as a result, save the EAT on the value of the real property.
Use of Dual Wills
The use of dual Wills (sometimes called “Public” and “Private” Wills, or “Primary” and “Secondary” Wills) was a strategy developed to minimize the EAT payable by an estate. As set out above, EAT is payable on the value of the assets governed by the Will which has been submitted for a Certificate. By having two Wills, a testator can effectively separate his or her assets into two pools: those which require the Certificate to be dealt with, and those which do not.
Minimization of EAT for individuals with real property of significant value involves transferring legal ownership of the property (as opposed to beneficial ownership) into a nominee corporation. On the death of the beneficial owner of the property, the nominee corporation is governed by the terms of the Will not submitted for the Certificate, and EAT is not payable on the value of the corporation (i.e. the value of the property).
The transfer of beneficial ownership to the nominee corporation does not have significant tax implications. Because only legal title to the property is transferred, the value of the consideration transferred to the nominee corporation is nil, and LTT is accordingly nil. The beneficial owner has to file an affidavit in conjunction with the conveyance of legal title to the nominee corporation, setting out the facts of the nil transfer, in order to qualify for the nil LTT. In addition, as the testator is the beneficial owner of the property, there is no disposition on the transfer of the legal title to the trust, and no corresponding capital gains giving rise to tax. The testator’s estate can still claim the PRE on the property on death, if applicable (otherwise, the usual capital gains tax will apply).
There are up-front costs involved in the set-up of a nominee corporation, as well as ongoing reporting requirements for the corporation. Accordingly, the use of a nominee corporation only makes sense where the property is of significant value, such that the EAT savings would outweigh the set-up and maintenance costs of the nominee corporation.
The Use of Trusts
A trust established during a person’s lifetime is called an “inter vivos” trust, and a trust created by Will (i.e. a trust that doesn’t come into effect until a person is deceased) is called a “testamentary” trust. Both can be used as part of a comprehensive estate plan to minimize or defer taxes related to real property. Transferring property into an inter vivos trust avoids the payment of EAT on the death of the transferor, as the transferor no longer owns the property and it does not form part of the transferor’s estate. The trust may be structured in such a way as to allow the settlor (the person who establishes the trust) to continue to enjoy the property during his or her lifetime, with the property continuing to be held for the benefit of beneficiaries following the settlor’s death, or distributed at the date of death of the settlor to one or more beneficiaries.
There are, however, capital gains tax consequences associated with transfers to an inter vivos trust (other than a spousal, alter ego or joint partner trust). First, unless the property is designated as the settlor’s principal residence and the PRE applies, capital gains taxes will be payable at the time the property is transferred to the trust. These taxes can be substantial. Consequently, many people choose to hold assets personally, such that they form part of their estate on death, as an estate often has greater liquidity to meet the capital gains tax obligations (as a result of life insurance and the disposition of other assets) than a person has while alive. Second, the ITA provides that there is a deemed disposition of the trust property every 21 years, at which point capital gains taxes are payable on the property. As a result of this deemed disposition, the trust property of many inter vivos trusts is typically distributed before the 21st anniversary of the trust to avoid paying the capital gains taxes resulting from this deemed disposition. If the property in the trust is intended to be held for more than 21 years, a plan should be in place to ensure that the capital gains taxes arising on the deemed disposition can be funded. The Department of Finance has recently proposed new changes to the ITA that strictly limit the designation of a property held in trust as a principal residence. While a full discussion of the changes is beyond the scope of this paper, there are now very limited circumstances in which an inter vivos trust may claim the PRE. Accordingly, the use of an inter vivos trust as an estate planning mechanism likely only makes sense now, in most cases, for a secondary property.
Alter Ego and Joint Partner Trusts
Canadians over the age of 65 have additional estate-planning options available to them: they can use an alter ego trust or joint partner trust to avoid the payment of EAT. An alter ego trust is an inter vivos trust, for which the settlor is entitled to receive all income from the trust during his or her lifetime, and only the settlor may receive capital from the trust during his or her lifetime. Similarly, a joint partner trust is an inter vivos trust, for which the settlor and his or her spouse are entitled to receive all income from the trust during their lifetimes, and only the settlor and his or her spouse may receive capital from the trust during their lifetimes.
An individual can transfer property into the alter ego or joint partner trust without incurring capital gains; the capital gains are deferred until the death of the settlor (in the case of alter ego trusts) or the death of the survivor of the settlor and his or her spouse (in the case of joint partner trusts). In addition, unlike other inter vivos trusts, there is no deemed disposition of the trust property every 21 years. On the death of the settlor of an alter ego trust, or on the death of the survivor of the settlor and the settlor’s spouse of a joint partner trust, the property held in the trust does not form part of the deceased’s estate and is not subject to EAT. Instead, the property is distributed in accordance of the terms of the trust instrument.
A spousal trust is a trust held for the benefit of the settlor’s spouse. The spouse must be entitled to receive the entirety of the income from the trust during his or her lifetime, and no one other than the spouse can be entitled to receive capital from the trust (though the spouse does not have to receive any capital). A spousal trust may be an inter vivos trust, or a testamentary one. The primary advantage to using a spousal trust is that the trust benefits from the deferment of capital gains taxes until the death of the spouse, without having to fully transfer ownership of the assets to the spouse. In addition, where the spousal trust is an inter vivos trust, no EAT arises on the death of the settlor on the value of the trust assets. Spousal trusts are particularly useful in a second marriage, where the settlor (or testator) wishes to benefit his or her spouse and benefit from deferred capital gains taxes, but would ultimately like for his or her children from a previous relationship to receive the trust property.