How Deemed Disposition at Death Is Reported on the Final Return in Canada

Many executors are surprised to learn that tax on investments, a cottage or a rental property can arise even though nothing is sold. This comes from the deemed disposition rule, which applies when a person dies.

This article explains where and how the gains are reported on the final return, and the main ways the tax can be reduced or deferred. It is general information, so an accountant or lawyer can confirm how it applies to the estate.

This article covers Canadian federal tax law, which applies in every province.

What deemed disposition means

Under Income Tax Act s. 70(5), on death each capital property is deemed sold immediately before death at fair market value, and the person who acquires it is deemed to acquire it at that value. The gain is taxed on the final return even if the property is not sold.

In plain terms, the tax system treats the death as a sale. The executor needs a reasonable value for each asset as of the date of death, so appraisals and account statements matter.

The legal representative is usually the executor named in the will (in Québec, the liquidator), and is responsible for ensuring returns are filed and balances owing are resolved.

Where it is reported

The taxable capital gain or loss is calculated on Schedule 3 and reported on line 12700 of the final return. Use the T1 package for the year of death and the province of residence at death, plus Form 428 outside Québec.

Ways the tax may be reduced or deferred

• Spousal rollover: property passing to a surviving spouse or common-law partner who was a Canadian resident can roll over without a gain or loss if it vests in them within 36 months of death, and the legal representative can elect out property by property.
• Principal residence: gains may be exempt only if designated on Schedule 3 and Form T1255 in the final return, though this is not needed if the property rolls to a spouse.
• Lifetime capital gains deduction: qualified farm or fishing property and qualified small business corporation shares may qualify.
• Losses: net capital losses of the final and prior year can offset other income, but personal-use property losses cannot be claimed except on listed personal property.

RRSPs and RRIFs are treated differently from other capital property. The deceased is treated as receiving the fair market value of an unmatured RRSP just before death, with a spousal rollover available in some cases. If all plan property is transferred directly to the survivor's RRSP, RRIF, PRPP, SPP or an eligible annuity before the end of the year after death, no T4RSP is issued in the deceased's name.

Limits and related points

When claims are split between the final and optional returns, the total cannot be more than what would have been allowed on the final return alone. Funeral expenses, probate fees and estate administration fees are not deductible. Capital gains are not rights or things, so they cannot go on a separate rights or things return.

Income the estate earns after death is reported on the T3 return rather than the final T1. Tax owing should also be settled before beneficiaries are paid, because the legal representative who distributes without a clearance certificate can be personally liable up to the value distributed.

Timing matters because a late final return with a balance owing carries a penalty of 5% of the balance plus 1% of the balance for each full month late, up to 12 months. Interest is compounded daily on unpaid amounts from the day after the due date until paid.

What to do next

• List every asset and get its fair market value at the date of death.
• Find the original cost of each asset to work out the gain.
• Decide whether any property goes to a surviving spouse or common-law partner and whether to elect out of the rollover.
• Identify any principal residence and prepare Form T1255.
• Collect T4, T5 and other slips.
• Confirm the filing and payment dates for the year of death.

Because the tax can be large and the choices interact, consider having an accountant prepare Schedule 3 and a lawyer review the estate plan before anything is distributed.

Frequently asked questions