Leaving real property to a beneficiary in your Will seems straightforward — but if that property is not your principal residence, the tax consequences require careful thought.
The Principal Residence Exemption
When you sell or give away your primary home, you can generally claim the principal residence exemption and pay no capital gains tax on the appreciation. This is a significant benefit most homeowners are familiar with.
But if you own a second property — a cottage, a rental property, a vacant lot, a property you inherited — it likely does not qualify as your principal residence. When you leave this property in your Will, the transfer to your beneficiary on death triggers a deemed disposition at fair market value. Any gain above your cost base is a taxable capital gain reported on your final tax return.
What Is a Deemed Disposition?
For tax purposes, death is treated as if you sold all your property at fair market value on the date of death. You do not actually sell it — your estate receives it and passes it to the beneficiary — but the gain is calculated as if you did. The resulting capital gains tax is a liability of your estate, paid before the property is distributed to the beneficiary.
Example
You own a cottage you purchased for $80,000 thirty years ago. At your death it is worth $400,000. The deemed disposition triggers a capital gain of $320,000. Half of that ($160,000) is added to your income for the year of death and taxed at your marginal rate. The resulting tax — potentially $60,000-$80,000 or more — is a debt of your estate.
Planning Strategies
Several strategies can reduce or defer this tax, including transferring the property to a spouse at cost (with the gain deferred to the surviving spouse's death), selling the property during your lifetime and managing the gain over time, or holding the property in a corporation. Each approach has different implications. An accountant or estate lawyer should be involved in any significant non-principal-residence property planning.
Life Insurance as a Tax Solution
A simple approach many families use is to hold a life insurance policy on the property owner specifically sized to cover the expected capital gains tax on death. The insurance proceeds pay the tax bill, and the property passes to the beneficiary without being sold to fund the tax.