Electing out of spousal rollover on death

Background: The Death of a Taxpayer – Electing Out of the Spousal Rollover on Death

When a Canadian tax resident taxpayer passes away, he or she is deemed by the Income Tax Act to have sold all of his or her capital property for its fair market value immediately prior to his or her death. This has the effect of realizing all of the deceased taxpayer's previously unrealized capital gains and losses. Any person who then inherits property from the deceased taxpayer is deemed to have acquired that property for its fair market value as of immediately prior to the taxpayer's death.

The deceased taxpayer's executor is required to file a final T1 personal tax return on behalf of the deceased taxpayer. The taxation period covered by the final return begins on January 1 of the calendar year in which the taxpayer passed away and ends on the day the taxpayer passed away. As the deemed sale of the deceased taxpayer's property is deemed to happen immediately prior to death, the income or loss from the deemed sale is reported on the deceased taxpayer's final T1 tax return.

The taxpayer's estate will also need to file income tax returns for the duration of its existence and pay tax on the income it earns. The first day after the taxpayer's death is the first day of the first tax year of the estate. Some estates that do not earn income or distribute property to their beneficiaries may not be required to file tax returns.

Under Canadian income tax law, an inheritance is not taxable income. So, the recipients of an inheritance do not pay Canadian income tax on property they inherit. Any tax liability is incurred by the estate of the deceased taxpayer.

The Spousal Rollover on Death – Electing Out of the Spousal Rollover on Death

If an individual receives property from his or her spouse because of the spouse's death, then by default a different set of rules apply which prevent any accrued gains or losses on that property from being realized. Instead of being deemed to sell the property at its fair market value, the deceased taxpayer is deemed to have sold his or her that property at its cost to the deceased's spouse. This means that the deceased taxpayer will not realize any gains or losses with respect to that property.

The surviving spouse will then be deemed to have acquired the property he or she inherits at the property's cost amount to the deceased spouse. As such, immediately after receiving the property, the surviving spouse will have the same set of unrealized gains and losses as the deceased taxpayer had immediately prior to his or her death. A transaction with this type of tax deferral treatment is generally called a "rollover" and specifically in this case is referred to as a spousal rollover. Note that a spousal rollover is available on any transfer between spouses, not just as a result of death.

This spousal rollover treatment is normally beneficial when the deceased spouse had unrealized capital gains on the property transferred. This is because the rollover defers the payment of income tax on the capital gain until a later date, being the actual sale of the property or the death of the surviving spouse. Unless the property declines in value at some point in the future, eventually the property will be sold or otherwise disposed of which will result in the gain that existed at the time of the deceased spouse's death being realized and taxed. However, if the requirement to pay tax is pushed further into the future, the relevant taxpayer can invest and earn a return on the amount that would otherwise be needed to pay the tax. This type of tax benefit can be substantial if the unrealized gain is large or the property is not sold by the surviving spouse for many years. Tax deferral is a basic and important tax planning technique.

Electing Out of the Rollover – Electing Out of the Spousal Rollover on Death

The spousal rollover treatment for property received by a surviving spouse as a consequence of the death of his or her spouse applies automatically. It is however possible to opt out of the rollover treatment if the deceased spouse's executor files a corresponding election with the deceased spouse's final return. This election can specify on a property by property basis which property should receive spousal rollover treatment or not. The election cannot be partially applied to a single property. The decision to file the election is in the control of the deceased taxpayer's executor. The executor does not require the consent of the surviving spouse to make the election and the surviving spouse cannot otherwise control whether the election is made.

Property to which the election is applied will receive the default treatment described in the first section of this article (e.g. deemed to be sold at fair market value immediately before death). Despite the potential deferral advantages of rollover treatment, sometimes it is better for the estate of the deceased taxpayer to consult with an expert Canadian tax lawyer in order to realize a capital gain or loss, and hence for the executor to file the election. One example is if the deceased held property eligible for the lifetime capital gains exemption [IT1] , in which case it could make sense to make the election so as to make use of the exemption.

Another possible example is a situation where the deceased spouse has substantial unused capital losses from previous tax years. That could allow some gains to be realized without additional tax payable, which would give the surviving spouse a higher cost base in the property they receive and use up the capital losses that might otherwise become useless. Crystallizing capital losses by electing out of the spousal rollover may also be useful if there are capital gains in prior years that can be offset by carrying back the crystallized capital losses.

With proper estate planning, including evaluation of whether to elect out of the spousal rollover on death, it is often possible to achieve a substantially better tax outcome. 

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm and is a Certified Specialist in Taxation Law who has completed the CICA in-depth tax planning course. He appears regularly in print, radio and TV and blogs extensively.

With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, cryptocurrency traders, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax audit representation and tax litigation. Visit www.Taxpage.com and email David at david@taxpage.com. This article is an abridged version published on Mondaq.com.