Although Canada does not have an estate tax, it does impose a significant capital gains tax at death through a mechanism called "deemed disposition." Understanding how this works — and what you can do to minimize the tax burden on your estate — is one of the most important aspects of estate planning for Canadians with appreciated assets.
Under the Income Tax Act, when you die you are deemed to have disposed of (sold) all your capital property at fair market value immediately before death. This is called a "deemed disposition." You never actually sold anything, but the tax rules treat the death as a deemed sale, triggering capital gains tax on any appreciation.
The resulting capital gain is included in your terminal return (the last personal income tax return filed on your behalf) and taxed at your applicable marginal rate on the taxable portion of the gain.
Not all of a capital gain is taxable — only the "taxable capital gain" is included in income. The inclusion rate determines what percentage of the gain is taxable:
For most estates, the terminal return will have a significant amount of capital gains from all assets combined, pushing well above the $250,000 threshold and into the higher inclusion rate.
Nearly all capital property is subject to deemed disposition at death, including:
You can designate your principal residence (the home where you ordinarily live) for any or all years you own it, and the capital gain for those years is fully exempt. The exemption completely eliminates capital gains tax on the appreciation of your primary home for most Canadians.
One designation per family unit per year. If you own both a house and a cottage, you must allocate each year's designation to one property. Strategic allocation between properties can minimize total capital gains exposure, but only one can be the "principal residence" in any given year.
Capital property left to a surviving spouse or common-law partner rolls over at cost (ACB) — no deemed disposition occurs at the first death. The capital gain is deferred until the surviving spouse disposes of the property or dies. This is the most powerful tax deferral tool in Canadian estate planning and is available automatically unless you elect otherwise.
On the second death (or if the surviving spouse sells the property), the deferred capital gain becomes taxable. Planning for the ultimate tax liability — typically through life insurance — is important for estates with significant appreciated assets.
If you have capital losses in the year of death, they can generally offset capital gains on the terminal return. If you have more capital losses than gains on the terminal return, the unused losses can sometimes be applied to the year prior (through a "carryback" on the terminal return) or to the estate's income. An accountant can optimize the use of capital losses in the estate.
If you own both a city home and a cottage, calculate which property benefits most from the exemption and allocate years accordingly. A tax advisor can optimize the designation over your ownership period.
"Crystallizing" gains during your lifetime — especially in low-income years — allows you to pay tax at lower marginal rates than the terminal year, which typically has significant income from all sources. You can then reinvest with a higher ACB.
A permanent life insurance policy can fund the anticipated capital gains tax at death, allowing your heirs to keep the appreciated assets rather than selling them to pay CRA.
Transferring appreciated non-principal-residence property to adult children during your lifetime triggers capital gains immediately, but you pay tax at current rates rather than having the estate pay on potentially much larger values at a future date. This must be weighed against the current tax cost.
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