Avoiding Hidden Tax Liability for Your Heirs

Let’s say you bought a cabin in the Rockies many moons ago for $80,000. The property has already tripled in value, and by the time you pass you expect it will be worth about $400,000. The capital gain on your cozy cabin is $320,000. With a marginal tax rate of 45%, a capital gains tax of $72,000 would be due. Rather than enjoying family retreats at the cabin, your heirs may have to sell the property in order to be able to pay this tax.

This is just a hypothetical scenario, but it happens all too often, and not just with real estate property. Any successful investments or businesses that have multiplied in value will be subject to hefty capital gains taxes.

You can avoid these substantial tax liabilities by understanding how capital gains tax is applied and calculated, and to which assets the tax will apply. Next, you can prepare for capital gains tax as part of your estate planning by leaving funds to cover the tax after you’re gone.

Calculating Capital Gains Tax

Capital gain is the difference between the fair market of an asset (like a home, business, or stock) at the time of your death and the price you paid for it, with some minor variances depending on the asset. Capital gains tax is 50% of the value of the capital gain, as demonstrated in our earlier cabin example. Capital gains tax applies to property like non-registered investments, real estate other than your principal residence, share or partnership in a family business, and personal assets like vehicles, jewellery, and artwork.

Offsetting the Tax Liability For Your Heirs

A common way to offset the expected tax liability is to purchase a life insurance policy that names your heirs as beneficiaries. This policy should be insured for an amount that sufficiently covers the expected capital gains tax.

This is a wise strategy as insurance proceeds are tax-free and do not go through probate. With a guaranteed payout and affordable premiums, life insurance is generally recommended ahead of alternatives. Considering the downsides of having to pay interest on a loan or selling the assets below market value, life insurance is the best option for offsetting the tax liability.

RRSP/RRIF Tax Liability

Beyond capital gains tax, you must also account for the potential tax liability when your Registered Retirement Savings Plan (RRSP) and Registered Retirement Income Fund (RRIF) transfer into your income. You can defer taxation by transferring the funds into the RRSP/RRIF of your spouse or financially dependent child. Alternatively, you may wish to donate the proceeds of your registered plans to a designated charity. While charity donations are ordinarily limited to 75% of net income, you may donate 100% of net income in the year or immediately preceding year of your death.

It is extremely important to consider the tax liability during the estate planning process. As part of The Beacon Group of Assante Financial Management Ltd.’s Lifetime Legacy Advantage, we will help you develop estate planning strategies that provide your heirs with a secure future.