Spousal Rollover at Death in Canada: Is Capital Gains Tax Avoided?

When someone dies owning investments, a rental property or a cottage, the usual worry is a large tax bill on the final return. Many people have heard that leaving property to a spouse avoids this tax. That is partly true, but the details matter, and the word "avoids" is not quite right.

This article explains the federal spousal rollover in the Income Tax Act, who qualifies, the conditions that can trip it up, and why a legal representative might choose to turn it off. It is general information only. Your own facts, the will and the type of property all affect the result.

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

The usual rule: deemed sale at fair market value

On death, a taxpayer is deemed to have disposed of each capital property immediately before death for proceeds equal to its fair market value. The tax on any gain is carried by the final return, not by an inheritance tax.

The person who acquires the property because of the death is deemed to acquire it at that same fair market value, which sets their adjusted cost base. The gain or loss on the final return is fair market value on the date of death minus the adjusted cost base, reported on Schedule 3.

What the spousal rollover changes

Where property of a taxpayer resident in Canada immediately before death is transferred or distributed as a consequence of death to a spouse or common-law partner resident in Canada, the usual fair market value rules do not apply. Instead, the deceased is deemed to dispose of the property for proceeds equal to its adjusted cost base (for depreciable property, the lesser of capital cost and cost amount), and the spouse is deemed to acquire it at that same amount.

In plain words, no gain is triggered on the final return for that property, and the spouse steps into the deceased's tax position. The built-in gain is not erased. It travels with the property until the spouse sells it or dies, so the rollover postpones tax rather than cancelling it.

Who and what qualifies

The rollover also applies to a trust created by the deceased's will that is resident in Canada, if the spouse is entitled to receive all of the trust's income for life and no one else may get income or capital of the trust during the spouse's lifetime.

The conditions to check are:

• The deceased was resident in Canada immediately before death.
• The spouse or common-law partner was resident in Canada immediately before the death. A non-resident spouse does not qualify, and the ordinary deemed disposition at fair market value applies.
• The property is transferred or distributed to the spouse or the qualifying trust as a consequence of death.
• The property vests indefeasibly in the spouse or trust within 36 months after death, or a longer period the Minister allows on written application.

"Vests indefeasibly" means, in general terms, that the property is locked in as belonging to the spouse or trust. The CRA describes this as being locked in within 36 months of death.

Opting out of the rollover

The legal representative may elect, in the final return for the year of death, that the rollover not apply, so that the regular deemed disposition at fair market value applies instead. The CRA says the election is made property by property, and proceeds are then set at fair market value.

Why would anyone choose to pay tax sooner? The election can be useful to use the deceased's losses, the capital gains deduction, or lower rates on the final return. Whether that is worthwhile depends on the numbers.

• Losses: net capital losses of other years are claimed on line 25300 of the final return.
• Capital gains deduction: gains on qualified small business corporation shares or qualified farm or fishing property may be eligible for the lifetime capital gains deduction, claimed on line 25400 using Form T657. The current limit and its status are worth confirming with the CRA or an accountant.

The gain comes back later, and other special cases

Because the spouse takes over the deceased's adjusted cost base, a later sale by the spouse is measured against that carried-over cost. The deferred gain is then part of what the spouse reports.

Some property follows different rules. Farm or fishing property passing to a child allows the legal representative to choose a deemed proceeds amount between the adjusted cost base (or cost amount) and fair market value.

A home may be fully or partly exempt as a principal residence, but it must still be reported on Schedule 3 and designated on Form T1255.

What to do next

Start by listing each capital property, its adjusted cost base and its date-of-death value. The CRA tells owners to keep records of fair market value on the date of death. Then work through who is receiving each item and where that person lives.

• Confirm the spouse or partner was resident in Canada at the date of death.
• Calendar the 36-month vesting date, and ask about a written application if more time is needed.
• Ask your accountant to compare the rollover with the opt-out for each property.
• Note the final return due date: April 30 of the following year for a death from January 1 to October 31, or six months after death for a death from November 1 to December 31. Different dates apply if a business was carried on.
• Before distributing property, get the clearance certificate. Without it, the legal representative can be personally liable up to the value of the property distributed.

Estates with a will trust, a business, farm property or a non-resident beneficiary are where mistakes are most costly. A lawyer or accountant can confirm how the rules apply to your facts.

Frequently asked questions