Inheritance Tax Canada: A Simple Guide to How the CRA Taxes Inheritances
Written by John Woodfield Portfolio Manager, CFP®, CIM® and Tiffany Woodfield, TEP, Associate Portfolio Manager, CRPC®, CIM®
Understanding Inheritance Tax and Estate Planning in Canada
Unlike many other countries that impose a direct tax on inheritances, Canada's approach to taxing inheritances is more nuanced and indirect.
If you’re about to get an inheritance, you may be worried that you’ll have to pay tax on your inheritance. Likewise, if you’re doing your estate planning, you’ll likely want to maximize what your loved ones will receive and ensure that a huge chunk isn’t eaten up by tax.
This guide aims to demystify the stance of the Canada Revenue Agency (CRA) on inheritance tax, clarifying how estates are taxed upon transfer.
Many Canadians worry about inheritance taxes, and rightly so. While Canada does not levy a direct inheritance tax, there are still tax implications that beneficiaries and executors must navigate. Understanding these nuances is crucial for effective estate planning and ensuring a smooth transition of assets.
Please seek advice from an accountant and lawyer when planning your estate. This provides a general overview and is not individual advice.
Key Points:
- Canada does not impose a direct inheritance tax; tax implications are indirect.
- Upon death, assets are deemed disposed of, possibly incurring capital gains taxes.
- Probate fees vary by province and are distinct from inheritance tax.
- Planning for the Principal Residence Exemption is vital if an estate contains multiple properties.
- RRSPs and RRIFs may be taxed if not transferred to a spouse or qualified dependant.
- Estates can be taxed as separate entities with distinct rules and rates.
- Understanding tax rules for trusts and strategic estate planning can mitigate tax impacts.
- Canadians face withholding tax on inheritances from abroad, with specific rules for U.S. inheritances.
- U.S. residents don't typically pay U.S. tax on Canadian inheritances but must consider state taxes and filing requirements.
- Key strategies include utilizing tax-advantaged accounts, spreading income out, and considering gifts to family members.
- Life insurance and trusts can offer tax benefits and asset protection.
- Professional advice is recommended for dealing with cross-border inheritances, estate planning, and any large estate in Canada.
Inheritance Tax Basics in Canada
Below are six different areas that tend to confuse regarding inheritance tax in Canada. Let’s look at each one in brief.
Capital Gains Tax on Deemed Disposition
Upon death, the CRA treats the deceased's assets as if they were sold just before death, potentially triggering capital gains tax. This concept, known as "deemed disposition," can be perplexing because it applies a tax to unrealized gains without an actual sale. (+)
Principal Residence Exemption
The rules around the principal residence exemption for capital gains tax can be complex, especially when the property has not always been the principal residence or is shared among multiple beneficiaries. (+)
Probate Fees vs. Inheritance Tax
Some people confuse probate fees with an inheritance tax. Probate fees are charged by provinces on the value of the estate being transferred, not by the federal government, and the rates vary significantly across provinces.
Taxation of RRSPs and RRIFs
Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) are treated differently upon death. Unless rolled over to a surviving spouse or financially dependent child, these accounts are taxed as income in the year of death, which can lead to a significant tax burden.
Estate as a Separate Tax Entity
The concept that the estate itself can be a separate tax entity and may be subject to different rules and tax rates for its income, including after the individual's death, adds another layer of complexity.
Taxation of Trusts
The rules regarding trusts, particularly testamentary trusts created due to someone's death, involve intricate tax treatment and rates, further complicating the landscape. In addition, while family trusts may be an excellent part of your estate planning process, you still need to consider how taxation will be handled.
Is Inheritance Taxable in Canada?
There is no inheritance tax in Canada.
In addition, you don’t have to report the money you inherit as income. When an individual passes away, a final tax return is prepared on income the deceased earned up to their date of death. Any taxes owed are usually paid from the deceased individual's estate before the remaining funds are transferred to beneficiaries. So, essentially, a beneficiary is receiving an after-tax inheritance.*
Example:
Let’s say that Julia has an estate valued at $6 million when she dies. Her estate could be subject to capital gains tax, if her assets have increased in value since she purchased them. Julia has a vacation home that has appreciated significantly. Upon her death, the estate must pay taxes on the capital gains (the increase in value from the time of purchase to the time of death) before the home can be passed on to their children. However, the children or beneficiaries receiving the home or other assets are not taxed just for receiving them. The essential taxes are handled by the estate before distribution.
*Some rollovers and elections may be available, so speaking to your accountant and lawyer is essential.
How Your Inheritance Is Taxed in Canada
When a person passes away, all of their assets are “deemed” to have been disposed of.
So, it is like you sold everything right before you died. Any capital property, such as investments or real estate, that has increased in value may realize a capital gain and can result in taxes payable by the deceased’s estate.* These capital gains can mean taxation of over 54 per cent on some assets.
There is also probate, which some people consider an additional tax because it is a percentage based on the value of assets that go through the will and need to be probated. The rates and rules for the various provinces are different, so it is crucial to work with a lawyer who knows the rules in your province. Probate is a relatively simple process that ensures the will is valid, the executor has authorization to act, and the testator’s wishes are followed.
*Investments or real estate that don’t qualify for a rollover or the Principal Residence Exemption can be taxable to the deceased’s estate.
Tax Challenges for Canadians With Inheritances Abroad
While the IRS doesn’t impose taxes on a foreign inheritance, if you are a dual citizen or resident alien, you may owe taxes, depending on the state in which you live.
In addition, when a non-resident of Canada receives an inheritance, the executor will usually hold 25 per cent as a withholding tax before distributing funds to the non-resident. The Canadian beneficiaries must deposit the 25 per cent to the CRA by the 15th month after the inheritance is given. This amount may be less than 25 per cent in countries where Canada has a tax treaty.
Beneficiaries in the U.S. have a set-out procedure once the funds make it through Canadian probate and taxes. There is no federal tax, but there may be state taxes.
As cross-border advisors, we have a great deal of experience working with the flow of investments through an estate across international borders. We often deal with inheritances across the Canada/U.S. border. However, we are not lawyers or accountants, and we strongly suggest readers seek advice from a qualified professional.
Here are some common questions asked by many of our U.S. clients when they inherit funds from Canada:
1. Do U.S. residents pay U.S. tax on inheritance money from Canada?
U.S. residents do not typically pay the U.S. Federal inheritance tax on money or assets inherited from Canada, because the U.S. does not levy an inheritance tax on beneficiaries. However, the U.S. does impose estate taxes on the decedent's estate before assets are distributed to beneficiaries. U.S. residents must consider U.S. income tax and may need to file an FBAR and fill out form 3520.
2. How much money can you receive as an inheritance from Canada?
Canada has no limit on how much money you can receive as an inheritance. In addition, unlike some countries that may impose taxes or restrictions on the amount inherited, Canada does not tax the beneficiaries directly on the money or assets they inherit. The taxes are handled by the estate before the distribution of assets. Therefore, a beneficiary in Canada could potentially receive any amount from an estate, whether it's a small sum or millions of dollars, without having to pay inheritance tax on that amount.
3. What IRS tax form do I need to file if I receive an inheritance?
If you're a Canadian resident receiving an inheritance from the U.S., you typically wouldn't need to file any IRS tax forms solely because of receiving the inheritance. The U.S. does not impose inheritance taxes on beneficiaries. The deceased's estate is responsible for any estate taxes to the IRS before the distribution of the inheritance.
However, there are a few scenarios where you might need to interact with IRS forms or have tax considerations:
1) Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts:
If you receive a distribution from a U.S. trust or a large gift from a U.S. person, you might need to file Form 3520 with the IRS. However, this form is more commonly associated with gifts or trust distributions rather than straightforward inheritances.
2) Income-Generating Assets:
If the inheritance includes assets that generate income in the U.S. (such as rental property or dividends from U.S. corporations), you may have U.S. tax filing obligations regarding that income. If required, you would report this income through the appropriate forms, such as Form 1040-NR and U.S. Nonresident Alien Income Tax Return.
3) U.S. Accounts and FBAR:
Suppose you inherit a large U.S. financial account. In that case, you might have to report obligations under the Foreign Bank and Financial Accounts Report (FBAR) to the Financial Crimes Enforcement Network (FinCEN), not directly to the IRS. If the total value of your foreign financial accounts exceeds $10,000 at any point during the calendar year, you will need to file an FBAR.
For most Canadian beneficiaries, the main concern is not with the IRS but with how the inheritance might affect their tax situation in Canada, particularly regarding any income generated by inherited assets.
It's critical to consult with a tax professional familiar with cross-border tax issues to ensure compliance and minimize the tax obligations in both countries.
Strategies To Help Your Beneficiaries Keep More of Their Inheritance
Optimizing your beneficiaries’ inheritance can involve a great deal of strategic planning.
You’ll want to work with an estate planning attorney if you have a large estate. You can set up trusts or use insurance to reduce taxes and freeze asset prices at a particular date. Smaller inheritances can look at pre-gifting or joint ownership of assets. Making sure that beneficiaries are set out in registered/tax-exempt plans is vital. Here are some key strategies for Canadians leaving an inheritance or inheriting assets from Canada or the U.S.:
- Utilize Tax-Efficient Accounts: To shelter future income or gains from taxes, consider transferring inherited funds into tax-advantaged accounts in Canada, such as a TFSA (Tax-Free Savings Account), providing you have contribution room.
- Spread Out Income: If you have a significant amount in an RRSP, consider taking withdrawals sooner than required. This allows you to spread out the income over several years, reducing the overall tax burden.
- Gifts to Family Members: There's no gift tax in Canada. If your estate is substantial, consider gifting portions to family members to support their financial needs, thereby indirectly reducing your taxable estate in the future. However, once you gift the assets, you no longer have control or ownership and this may be a factor in your decision.
- Invest Wisely: Invest the inheritance to balance growth with tax efficiency. Capital gains are taxed more favourably than interest income in Canada, so focusing on investments that yield capital gains can be beneficial.
- Life Insurance: If you expect to leave a large estate, consider purchasing life insurance. The death benefit paid to named beneficiaries is tax-free and can help to cover any estate taxes or fees, thereby preserving more of the estate for your heirs.
- Create a Trust: For larger estates, creating a trust can be a way to manage how your inheritance is distributed, potentially offering tax benefits and protecting assets from probate fees.
- Keep Records: Maintain detailed records of the inheritance's value at the time of receipt and any expenses related to maintaining or improving inherited properties. These records can be important for tax purposes.
- Review Beneficiary Designations: Ensure that retirement accounts, life insurance policies, and other assets with beneficiary designations are up to date to avoid unintended distributions that may result in additional taxes.
- Understand the Implications of a Cross-Border Inheritance: Work with a lawyer who is familiar with the Canada-U.S. tax treaty if your inheritance is from the U.S. Understanding cross-border implications can allow you to take advantage of credits or deductions to avoid double taxation.
- Seek Estate Planning Advice: If you are receiving an inheritance from the U.S., get advice from professionals specializing in cross-border estates. They can offer tailored advice based on your specific situation, potentially saving you significant taxes and fees.
Protecting Your Assets From Deemed Withdrawal Taxes
As mentioned previously, assets are deemed to have been sold in the terminal year.
Thus, any amount between the present price and the “cost base” comes into taxes as a capital gain, even though the assets may not have been sold.
Cost base refers to the original value of an asset for tax purposes. It's like keeping the receipt for something you buy, so you can figure out how much money you made or lost when you sell it later.
The cost base includes the purchase price plus any costs incurred to buy, improve, or sell the asset.
Your cost base is important because it helps determine how much tax you might owe when you sell the asset, based on the profit or loss from that original value. It is also important when dealing with an inheritance.
One way to reduce the tax on capital gains is to push up one’s cost base by realizing taxable capital gains or pre-gifting the funds. Also, more complex methods, such as trusts or estate freezes, can be used.
Working with an accountant and lawyer is vital to ensure this is completed correctly.
Inheritance Taxation of Spouses vs. Non-Spouses
Spousal and non-spousal inheritances are treated very differently under Canadian tax laws (and most other countries).
In Canada, when a spouse or common-law partner inherits assets, they are generally transferred tax-free, allowing the deferral of taxes until the surviving spouse sells the asset or passes away.
For non-spouses, such as children or other relatives, the deceased's estate may be subject to capital gains tax on appreciated assets before distribution.
This distinction underscores the tax-efficient transfer of assets between spouses, which is designed to provide financial stability for the surviving spouse, compared to the immediate tax implications that can arise when assets pass to non-spouses.
So long as wills are correctly constructed, beneficiary information is entered on registered plans, and assets are held jointly, then there should be a smooth transition between spouses when one passes away.
However, assets can be misallocated if someone passes intestate (with no will). Non-spouses have little or no tax relief unless dependency can be proven.
How Marriage Affects Inheritance Taxes
In Canada, marriage significantly impacts the handling of inheritance taxes.
Canada does not levy an inheritance tax per se but taxes the estate on the deemed disposition of assets upon death. Here’s how marriage affects this process:
Spousal Rollover
Assets transferred to a surviving spouse or common-law partner are done so on a tax-deferred basis. Any capital gains tax ordinarily due upon the deceased’s death is deferred until the surviving spouse sells the asset or dies. This provision allows the surviving spouse to inherit the estate without an immediate tax burden, preserving the estate's value.
Principal Residence Exemption
Suppose a principal residence is left to a surviving spouse. In that case, the property can continue to be considered a principal residence for the surviving spouse, potentially exempting it from capital gains tax until it is sold or transferred outside the spousal relationship.
RRSPs and RRIFs
Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) can be transferred to a surviving spouse without immediate tax implications. The tax is deferred until the spouse withdraws funds from the plan or fund, allowing the tax burden to be spread over time.
Estate Planning
Married couples often plan their estates together to take advantage of tax-saving strategies, such as naming each other as beneficiaries of RRSPs, RRIFs, and life insurance policies, to ensure tax-efficient transfer of assets.
While marriage provides opportunities to defer or minimize taxes on inheritance, couples must engage in estate planning to fully leverage these benefits. Couples should create wills that reflect their wishes and take advantage of spousal tax benefits to ensure the surviving spouse is financially secure while minimizing the tax burden on the estate.
Principal Residence Exemption
Fortunately, in Canada, if you file an election with CRA, you may be able to eliminate tax on the sale of your designated principal residence.
When a person passes, the principal residence is considered personal use property, and some or all the capital gains tax would most likely be covered if you meet certain criteria, by the principal residence exemption. The amount received from a principal residence sale is added to the estate and distributed as per the will. However, it is still subject to probate.To qualify for the Principal Residence Exemption (PRE), a property must meet specific criteria:
- It must be a housing unit, including a house, condominium, cottage, mobile home, or houseboat.
- The property must be owned by the individual or in a partnership with a spouse or common-law partner.
- The individual, their spouse, common-law partner, or their children must have ordinarily inhabited the property during the year.
For properties inherited by heirs other than a spouse, the estate can claim the PRE for the years the deceased owned and used the property as their principal residence, potentially reducing or eliminating capital gains tax up to death.
The heirs can then decide whether to designate the property as their principal residence, going forward, subject to the rules regarding the designation of principal residences.
Families with multiple properties (e.g., a primary home and a vacation cottage) must carefully plan which property to designate as the principal residence for each year to maximize the PRE.
Which property you designate as the principal residence can significantly affect the estate's tax liability upon the owner's death.
Maintaining thorough records of property use and ownership and any capital improvements made is vital for supporting the PRE claim upon the transfer of the property through inheritance. Estate planning discussions should include considerations about the PRE to ensure that the family's assets are managed in a tax-efficient manner.
What You Need To Know about Tax on Gifted Money
In Canada, you can give away as much money as you like during your lifetime, and there is no tax on you or those to whom you give the money.
However, the gain is taxable if you sell something or gift an asset with a capital gain. In Canada, 50 per cent of a capital gain is added to your income upon sale or gifting.
The Consequences of Ignoring Inheritance Tax Rules
Those who ignore the tax rules around inheritance will most likely face several issues.
First, probate is mandatory in most provinces on estates with assets above a certain value, that transfer through a will. Secondly, paying tax on deemed capital gains is tax law. Thirdly, those supposed to receive funds from an inheritance may be able to sue or make a claim against the executor/estate for what they feel they were owed. Ignoring the tax rules brings dire consequences.
1 - Penalties and Interest: If taxes due on an estate are not paid on time, the CRA can impose penalties and interest on the outstanding amount. These charges can accumulate quickly and increase the total tax liability.
2 - Delayed Distribution: Ignoring tax rules can lead to delays in the probate process and the distribution of assets. The CRA may require the settlement of any tax liabilities before assets can be legally transferred to beneficiaries, potentially delaying their access to inheritance.
3 - Reduced Inheritance: Failure to comply with tax laws can reduce the value of the inheritance through penalties, interest, and unnecessary taxes. Strategic tax planning, including exemptions and deductions, can minimize the estate's tax liability, maximizing the inheritance for beneficiaries.
4 - Legal Issues: Executors who fail to fulfill their tax-related responsibilities may face legal consequences. Executors are personally liable for ensuring the estate's taxes are correctly calculated and paid. If they distribute assets without settling tax debts, they can be held personally accountable for the unpaid taxes.
5 - Audits and Reassessments: The CRA may audit an estate if there are suspicions of tax evasion or improper filing. This audit can lead to reassessments and additional taxes, penalties, and interest, further depleting the estate's assets.
Probate and Probate Fees Explained
Probate is a critical step in inheritance, and each province has different probate fees.*
The probate process must be completed before the estate is paid out. Probate exists so that those designated to receive proceeds from an estate receive what is intended.
In short, probate is the process where the court verifies that a will is authentic. If the deceased does not have a will, the court will appoint a person to act on their behalf.
*In Québec, if you have a notarial will, probate is not required.
Understanding the Legal Side of Inheritance
Each Canadian province has different rules around how they handle an inheritance.
People can add anyone they like as a beneficiary and exclude anyone they do not want to inherit. Though this is true, it does not mean that someone disinherited cannot make a claim against an estate or make a dependant relief claim.
Common Questions About Inheritance Tax in Canada
While we can’t cover every single question about inheritance taxes in Canada, these are some of the most common questions and answers.
Please seek advice from an accountant and lawyer when planning your estate, as this is not a substitute for a professional consultation.
How much can you inherit without paying taxes in Canada?
In most cases, taxes are paid within the estate before the funds are paid out to the beneficiaries (as cross-border advisors, we know that IRAs inherited by a Canadian might have the option to be taxed over the subsequent 10 years). There is no limit to what can be inherited in Canada.
Basic ways to reduce estate taxes:
- Have named beneficiaries on all accounts where this is an option, such as an RRSP, TFSA, and insurance.
- Take advantage of available rollovers.
- Consider a trust.
- Consider purchasing life insurance to cover estate taxes and equalize an estate.
Does an inheritance count as income?
No, an inheritance does not count as income. In some cases, such as inheriting a U.S. IRA, the beneficiary pays the tax, though they can stretch out the withdrawals, and therefore tax liability, for up to 10 years.
Do I have to pay taxes on a house I inherited in Canada?
If you inherit a principal residence, there is generally no tax other than the probate fees paid within the estate. When looking at other properties, the estate will pay the capital gains on these assets. For any unsold property in an estate, the funds to cover the tax must come from other investments or holdings within the estate.
How do you avoid paying capital gains tax on inherited property in Canada?
Taxes on capital gains are paid through the estate. The inheritor has a new tax base when the property becomes theirs.
However, some strategies to minimize the tax obligation include estate freezes, purchasing insurance, and pre-gifting. These three options can potentially lower the taxes paid by the estate. These strategies must be initiated while the owner is still alive and involve them giving up rights to the property.
The idea is to either freeze or realize the present value, so that future value is paid by those who inherit the asset or create a pool of capital from insurance to cover estate costs.
How do Canadian inheritance tax laws work and what is taxable upon death in Canada?
Capital gains are taxed at death. All assets in the estate are considered to have been sold for fair market value when a person passes. Assets include real estate, businesses, land, investments and tax-deferred plans such as RRSPs. These assets are not all taxed the same way and rollovers may be available for qualified beneficiaries.
Qualified beneficiaries who receive funds without the estate paying tax may include a spouse/common-law partner, a financially dependent child or grandchild (under 18), and a disabled child or grandchild (no age limit).
Assets transferred through a will are included in the probate calculation, unless in Quebec, where the rules work differently.
Can I sell my house in Canada to my son or daughter for $1?
The short answer is, yes. You can sell your house in Canada for any amount you choose.
However, regardless of the amount you sold your property to your son or daughter for, it will be “deemed” to be sold for the FMV (fair market value). For example, if you had an asset that you sold to your kids for less that its FMV, thinking it will save you tax, you would be wrong. If the difference between your cost and the current actual value results in a capital gain, you will need to report this on your tax return, regardless of how much you “sold” it for.
Note that, in the case of your home, if you elect to have it designated as your principle residence and use the PRE (principle residence exemption), you wouldn’t have a taxable capital gain.
How much money can be legally given to a family member as a gift in Canada?
There are no limits to the amount you can gift in Canada, though any capital gains would be triggered, and taxes would need to be paid.
How do I transfer property to a family member tax-free in Canada?
Transferring property to a family member in Canada tax-free is relatively easy since Canada has no gift tax. Note that capital gains are realized by the person giving the gift, if the asset is in a gain position. Also, this may cause an issue if there is more than one potential beneficiary or limited resources for the person giving the gift.
What happens when you inherit a house in Canada?
Canada has no inheritance tax, so inheriting any Canadian-based asset is usually free of additional taxes beyond what was paid in the estate.
A Tip for Executors
Once you have paid all taxes and filed the terminal tax return, the CRA will send you a clearance certificate. A clearance certificate is the official confirmation that no further taxes are owed. If you disperse funds from the estate before receiving this, you could be held personally responsible for any further taxes owed.
Final Thoughts
The passing of a loved one comes with a variety of emotional and financial considerations. Navigating the intricacies of inheritance laws and tax in Canada requires careful planning and is a time-consuming and often frustrating experience. Organization is the key to making this process as smooth as possible, as is using the appropriate professionals in each step.
NEXT STEPS
If you’re a Canadian resident or are planning on moving to Canada or the U.S. and need assistance with moving and optimizing your investments, estate planning, wealth management and portfolio management, please get in touch. At SWAN Wealth, we specialize in Canadian financial planning, cross-border financial planning and cross-border wealth management.
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Moving to Canada from the U.S.
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ABOUT THE AUTHORS
Tiffany Woodfield is an Associate Portfolio Manager licensed in Canada and the USA, a Chartered Investment Manager (CIM), a Chartered Retirement Planning Counselor (CRPC) a Trust and Estate Practitioner (TEP) and the co-founder of SWAN Wealth Management, along with her husband, John Woodfield. Tiffany advises clients who live in Canada and the United States and want to simplify their cross-border financial plan, move their assets across the border, and optimize their investments to minimize their tax burden. Together, Tiffany and John Woodfield help their clients simplify their cross-border finances and create long-term revenue streams that will keep their assets safe whether they live in Canada or the U.S.
John Woodfield is a Financial Management Advisor (FMA), a Chartered Investment Manager (CIM), and a Certified Financial Planner (CFP), and, in 2007, was inducted as a Fellow of the Canadian Securities Institute (FCSI). As a portfolio manager and CFP®, he works with clients across Canada. John Woodfield’s clients are families, individuals and business owners who understand the importance of comprehensive wealth and investment plans driven by the lifestyle they want to lead.
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