The Importance of Tracking Your Adjusted Cost Base from an Inheritance

From an income tax perspective (I am obviously ignoring the emotional issues) receiving an inheritance provides two tax related benefits. The receipt of the inheritance is typically tax-free and you may also receive a “bump” (increase) in the adjusted cost base (“ACB”) of any capital property inherited.

However, over the years, I have seen cases where people pay unnecessary income tax and/or have disputes with the CRA because they (1) forget or are not aware of the cost base bump (2) have misplaced documentation or never obtained documentation (3) have switched accountants (or the original work was prepared by their parent’s accountants and is no longer accessible).

Today, I want to remind those of you who have inherited capital property, to ensure you have in place the documents (easily accessible) to support the ACB of any inherited property when you sell the property in the future.

Taxation on Death

I think to provide context for my comments, I first need to explain how the Income Tax Act works when someone passes away.

In Canada, where you receive cash or a cash like inheritance, there are no income tax implications. Where you inherit capital property, such as stocks and real estate, you will have no immediate income tax implications, plus you will inherit the “bumped-up” cost base of the capital property to the deceased.

By “bumped-up” I mean the following. When a person passes away there is a deemed disposition of the deceased persons capital property at the fair market value ("FMV") of the property right before the person's death (this is typically the last spouse or common-law partner to die, as the income tax allows a tax-free transfer of property to a surviving spouse or common-law partner).

For example; say your mother passed away in 2015 and she owned 1,000 shares of Royal Bank (ignoring stock splits) that were worth $80 a share at her passing, that had been purchased for $12,000 in 2001. (Note: The Royal Bank shares could have been transferred to your mother as a tax-free spousal transfer from your father on his passing or the shares could have been purchased directly by your mother, it is the same tax result).

Your mother’s estate would have filed a final (terminal) income tax return reporting a deemed capital gain of $68,000 (FMV at death of $80,000-$12,000 original cost). This deemed capital gain is known as a deemed disposition on death and occurs despite the fact the Royal Bank shares were not sold. This is because your mother was the last surviving spouse and owned the shares at her date of death. Your mother’s deemed disposition FMV of $80,000 becomes the new cost base of your inherited shares. So, if you sell the Royal Bank shares in the future, the gain would be equal to your sales proceeds less your bumped-up cost base of $80,000. 

The same thing would occur if your father/mom owned real estate. The fair market value at your mothers passing would become your new ACB, although there would be an allocation between land and building. The rules relating to the inheritance real estate can get tricky for a non-arm’s length decedent. You should speak to your accountant to get an accurate understanding of your cost base and allocation between land and building.

While I use parents in the above example, the same result occurs if you inherited the capital property from a relative or friend etc.

A totally separate but interrelated ACB tax issue, is the 1994 Capital Gains Election. In 1994, the $100,000 capital gains exemption was phased out. However, individuals were eligible to make an election on their 1994 personal tax return to bump the value of their capital properties by up to $100,000. Where you inherit capital property, if possible, before the accountant files the terminal return of the deceased, you should ask them if they have the 1994 election on file, or if not, see if you can find the deceased's 1994 return to determine if an election was made in 1994. If the election was made, it will likely have no impact on your inherited ACB, but it may reduce the tax on the terminal tax return of your parent or relative etc.

Supporting Your "Bumped- Up" Adjusted Cost Base

Now that I have provided the income tax context, I can discuss the importance of documentation, as without the documentation, you will not know the inherited cost base of your capital property.

The key documents you hopefully already have on hand or can dig up from a box in storage are:

1. The terminal income tax return of your last surviving parent. This return will reflect the deemed disposition of any capital property held on your parent’s passing on Schedule 3 -Dispositions of Capital Gains (or Losses). The proceeds of disposition on this form will form the new ACB of the inherited property to you. Using my prior example, Schedule 3 would reflect proceeds of disposition of $80,000 for the 1000 RBC shares held on death and the $80,000 would become your new ACB.

2. It is possible a parent who pre-deceased their spouse left property directly to you. If that is the case, you would need their terminal tax return to review their schedule 3.

3.  Tax reorganization memos from your parent’s accountants if they undertook any post-mortem tax planning for your parent(s) private corporations. Depending upon the reorganization, there could be ACB increases, although in many cases, the key planning is creating tax-free promissory notes.

An interesting capital asset is the principal residence (“PR”) of your parents or anyone else you inherited property from. If the house was inherited and not sold immediately (say you kept the PR as a rental property), then the FMV of the PR on the death of your parent becomes important. However, prior to 2016, when the sale of a PR had to start being reported on Schedule 3 (and from 2017 onwards when it had to be reported on Schedule T2091) administratively the CRA did not require you to report the sale of your PR if it had always been your PE and the sale was exempt from tax as your PR. 

Thus, you may need to obtain a real estate valuation for the value of the PR at the deceased's passing, since there may be no record of the FMV on death.

If you have inherited capital property from your parent’s or any other person, hopefully you already have the documentation discussed above in place. If not, it would be a very useful project to try and obtain the documents before you decide to sell the asset and are forced to scramble to find information that can be twenty or thirty years old.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Confessions of a Tax Season Accountant — 2021 Edition

In the old days of this blog, some readers may recall I wrote a series of posts titled “Confessions of a Tax Accountant” during income tax season. Those posts would discuss interesting or contentious income tax and filing issues that arose as I prepared my clients’ tax returns. Two years ago I condensed the confessions down to a single confession. Last year COVID struck. I didn’t confess last year. I just prayed.

Today, to bring some normalcy back to the blog, I will again provide a single tax season confession for the 2021 tax season.

Home office claims

The most important change for your 2020 tax filing is how you claim your home office expenses. I detailed these changes a month ago, so please refer there for more details.

A couple new tax credits

For 2020, there are a couple new tax credits:

• Digital News Subscription Credit – This non-refundable credit may be available if you paid for a digital news subscription in 2020. The limit is $500. You can find the details here.
• Canada Training Credit – Per the CRA, “Eligible workers of at least 25 years old and less than 65 years old at the end of 2019 and later years, and who meet certain conditions will accumulate $250 a year, up to a lifetime limit of $5,000 to be used in calculating their Canada Training Credit, a new refundable tax credit available for 2020 and future years. Based on the information on their return, the CRA will determine their Canada training credit limit for the 2020 tax year and provide it to them on their notice of assessment for 2019 and will be available in My Account.”

U.S. capital gains reports

I apologize for repeating this point—it’s at least the fourth time I’m mentioning it on the blog—but it is a major pet peeve of mine. Here goes: We continue to receive realized capital gains reports for clients for their U.S. holdings brokerage accounts that are not properly converted for Canadian taxes.

To properly report your U.S. or any foreign stocks trades, the original purchase should be converted at the exchange rate at the date of purchase (or, if not available, at the average exchange rate for the year of purchase), and the sale should be converted at the exchange rate on the date of sale (or, if not available, at the average exchange rate for 2020).

I continue to receive capital gain reports with both the purchase and sale converted at the 2020 average exchange rate. Since the U.S. dollar has risen over the years, a purchase made several years ago likely would have a large foreign exchange gain component that is not being reported.

Property received by inheritance

As baby boomers or, more particularly, their parents age and pass away, many Canadians have inherited real estate, stocks or other capital property. A tax season issue I have been noticing is that people who have inherited property and then sold it often do not know what their adjusted cost base is on the inherited property. This is problematic in determining the related capital gain.

The reason for this cost base gap is most typically that the child who inherited the property does not have a copy of their parent’s terminal tax return (final tax return of the parent for their year of death). On a terminal return, there is what is known as a deemed disposition that reports the fair market value of a deceased person’s real estate, stocks or other capital property. The deemed disposition amount would become the child’s adjusted cost base for when they sell the property.

This is best explained by an example. Say Mr. A and Mrs. A were the parents of Susan. Mr. A and Mrs. A owned a cottage property that was purchased many years ago for $200,000. When Mr. A passed away 10 years ago, he left the cottage to Mrs. A (this is typically a tax-free spousal transfer with no tax implications). However, Mrs. A passed away five years ago when the cottage was worth $900,000. When Mrs. A’s accountant filed her terminal return, they reported a deemed disposition of the real estate at $900,000 and paid capital gains tax on the gain of $700,000 ($900,000 value at death less $200,000 original cost). Susan’s adjusted cost base upon inheritance became the $900,000 deemed disposition amount.

Where you have inherited real estate, stocks or other capital property, it is important that you obtain and keep a copy your parent’s final tax return so you can provide your accountant the return to ensure the correct adjusted cost base if reported when you sell the property.

Medical receipts

Many clients provide multiple tax receipts for the same pharmacy or medical practitioner. Your accountant will love you if you ask the pharmacy and your medical practitioners to provide a yearly summary of all payments, so your accountant only has to deal with a few receipts instead of multiple receipts.

Here’s hoping you have a 2020 refund or owe less tax than you anticipated. 

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

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