My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, October 7, 2013

When Spouses Don’t Leave All Their Assets to Each Other - The Income Tax Implications

You must admit, nobody has as many uplifting titles for their blog posts as I do. I have previously had such cheery titles as “Stress Testing Your Death” and “Is it Morbid to Plan for an Inheritance”. So today, in keeping with my "Morbid Mark" theme, I will discuss the tax implications that can occur when one spouse passes away, and does not will all of their assets to their surviving spouse.

Deemed Disposition Upon Death

Upon death, you are deemed to have disposed of your capital and non-depreciable property (typically your principal residence is tax-free) for proceeds equal to the fair market value (“FMV”) of the assets immediately before death. If the FMV of any property is greater than the original cost of that property, your executor must report a capital gain on your income tax return for the year of death (known as a terminal return).

For example, if John passed away on September 1, 2013 and he owned shares of Bell Canada worth $40 on September 1st, that he had purchased for $28 several years ago, his estate must report a deemed capital gain of $12 per share on his terminal return. The same would hold true for a rental property, which may also have additional potential issues, such as the recapture of capital cost allowance (depreciation).

Automatic Spousal Rollover

There is an exception to the deemed disposition rule, where the property passes to the deceased spouse, common-law partner or a "qualifying spousal trust". In this situation, the transfer takes place at the adjusted cost base (ACB) of the property, not the FMV of the property and the deemed capital gain is deferred until the spouse or common-law partner dies; or the property is disposed of by the spouse or common-law partner. So if John was married to Mary and left everything to her in his will, the Bell Canada shares would transfer to Mary tax-free at a cost base of $28.

In the good old days of Ozzie and Harriet, the automatic provision was fairly standard. People stayed married and both spouses would usually have mirror wills, leaving all or most of their property to each other.

Today, with the high rate of divorce, second families and spouses who have independent thoughts, it is not that unusual for spouses to have different wills or wills in which they only leave some assets to their current spouse.

Where spouses have different wishes in their wills and don’t leave all their property to their surviving spouse, the deemed disposition rules noted above come into effect. The resultant income tax liability can in some cases be large and where assets are not liquid, the payment of those taxes can sometimes be problematic.

Why Would Spouses Have Different Wishes

There are a myriad of reasons why spouses may not have mirror wills or leave all their assets to each other. Here are some common reasons:

1. Second families- A testator may structure their will to only leave a certain amount to the surviving spouse, or to a spousal trust for their surviving spouse so they can leave other property and monies directly to their children from the first marriage; this triggers the deemed disposition rules on the property left to their children.

2. Black Sheep Children -One spouse may have an issue with one of their children and be concerned their surviving spouse will turn around and leave money to the black sheep child when they pass away.

3. DINKS – The “double income no kids” cohort often have other family members they wish to benefit from their estate, such as parents, siblings, nieces and nephews. They are confident that their surviving spouse has enough assets of their own and will not need a large inheritance in order to have a prosperous retirement. According to estates lawyer Katy Basi “The wills that we draft for childless testators are often long and sometimes quite complicated. The tax implications of the estate plan need to be carefully considered.”

4. Charitable Wishes – Spouses often have different charitable views. One spouse may want to leave a significant portion of their wealth to charity while the other does not. In this case, the concern is not an income tax issue, as the donation(s) eliminate most of the tax liability, but the issue becomes a question of whether assets must be liquidated to enable the executor to make the donations in the will.

As I have been told my blog posts are too long, I will stop here today. On Wednesday, I will discuss the income tax implications, liquidity concerns and planning issues when spouses don't leave all their assets to each other.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.