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Last week, Ed Rempel wrote a 2 part article about Universal Life Insurance.  At the end of that article, GatesVP asked a great question.  If you find the article a little long, you can skip to the end where I've written a summary of the important points.

Here is the original question: 

Now, if I’m understanding this correctly, paragraph 5 seems to imply that a Universal life insurance policy could actually help you “dodge” this tax burden? Is this correct? Can life insurance save me from paying taxes I owe?

And what about the cottage thing? If I give my kids the cottage before I die does it get taxed then? Why does it get taxed when I die then? I mean all of the money that paid for the property has already been taxed and it’s not like the kids are selling it. I mean if they sold it, then they’d definitely have to pay capital gains taxes, but they’re not, they’re just receiving it. Or am I totally off base there?

By the same respect then, can any life-insurance policy cancel out the capital gains taxes on properties? How else can I get around being forced to “cash out and pay taxes” on things I don’t want to “cash out”? How does this apply do collectibles, I mean what if I have an $50k, two-bedroom book collection are we collecting taxes on that stuff too? are we supposed to or does it normally just slip under the radar? Can I use the same “give to my children” trick? Could I do it over several years?

As I'm not a tax expert, I asked Ed Rempel (a CMA) to help answer the question. 

Here was the response:

In Canada, we do not have estate tax, like they do in the US on the value of large estates. In Canada, we only have INCOME tax on estates. It is assumed that all assets are sold and all RRSP’s cashed in on the date of death (unless passed on to a spouse). It is not a separate tax on the value of the estate - it is just income tax that has been deferred is now all due at once.

This applies to any real estate, other than your principal residence. Therefore, a cottage is deemed to be sold at fair market value when you die if you are passing it on to your kids. Capital gains tax will apply from when you originally bought it - which can be a large figure.

This is mainly only a problem if the kids want to keep the cottage and there is no significant liquid investments in your estate. If you have a huge investment portfolio or if your kids are will sell the cottage, then they have the cash to pay the tax. But if you have little else and they want to keep the cottage in the family, then how do they pay a $250,000 tax bill?

If you give the cottage to your kids earlier, then capital gains tax applies up until that date based on the fair market value. The “gift to my children trick” usually just results in paying tax sooner than if you wait.

Having insurance doesn’t change the tax. It just gives you some money to pay the tax.

Capital gains tax also appies to certain collectibles and personal investment assets (like gold bars, fine art), but they do not apply to depreciating personal use property like cars, or books.

(By the way, if you have $50K of books, are none of them about income tax?)

Gifts are not taxable and there is no limit on gifts (like there is in the US) - unless the gifts are taxable property (like real estate). Gifts of taxable property that are given as gifts or sold at low prices are deemed to be sold at fair market value.

Interesting question about inflation. Even though most of the appreciation of real estate is inflation - all of it is taxable. Many people have argued that only growth above inflation is real growth that should be taxable, but the Tax Act taxes it all.

Selling something to yourself is not a transaction. It you want to trigger the tax every year instead of deferring it (for some MAD reason), you have to give it or sell it to someone else.

You have some creative ideas, Gates, but triggering tax sooner is rarely a good idea. Much better is to either have life insurance to pay for it or just invest extra money.

Life insurance is more expensive than investing in tax-efficient investments. Fairly often, we have clients save a pot of money to pay taxes, instead of buying life insurance. Investments will build up a larger amount than life insurance - unless you die sooner than expected.

If you are saving for an increasing tax liability (like a cottage), an investment plan can be the most effective strategy. If you want protection now, then life insurance is usually the best option.

 To Summarize:

• There is no estate tax in Canada, upon passing, there is income tax applied to the estate as if everything was sold at market value.  RRSP's and principle residence can be passed to a spouse tax free.
• Cottages and vacation property upon passing will be deemed sold and capital gains tax applied (if there is a profit).
• If you give the vacation property to your children before you die, then the property is considered sold at market value.  Thus there is a potential capital gains tax to be paid by the vendor.
• Insurance doesn't change the tax payable, it provides money to pay for the taxes owed upon passing.
• Capital gains tax does not apply to depreciating personal use property like cars, books etc.

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