Death, Taxes, and Cryptocurrency: An Analysis by a Toronto Tax Lawyer
Published: November 17, 2022
Introduction: Taxation of NFT and Cryptocurrencies
Many Canadians now use cryptocurrencies like Chainlink, Cardano, Polkadot, Ethereum, and the most popular Bitcoin, as investment vehicles. NFTs, or Non-fungible Tokens, have also transformed the market for investing in works of art and collectibles.
With the value of the cryptocurrency and NFT markets rapidly increasing or sometimes decreasing, many Canadian cryptocurrencies and NFT investors need to understand the tax effects of holding and selling cryptocurrencies and NFTs. In this article, we'll look at some general legal concerns relating to how beneficiaries may be taxed after receiving the cryptocurrency and NFT investment portfolios after the owner-decedent’s death.
Capital Property Taxation at Death
Despite the fact that there is no "death tax" on inheritance in Canada, the Income Tax Act's subsection 70(5) will cause a deemed disposition of all of the deceased taxpayer's capital property at fair market value upon the demise of that taxpayer.
Section 70 additionally includes exception provisions for this deemed disposition rule when the deceased's capital property is bequeathed to the deceased's spouse, common-law partner, or a spousal trust. In some cases, tax on the deceased's accrued profits is suspended until the deceased's spouse, common-law partner, or spousal trust disposes of the property or is deemed to have disposed of the property.
However, there is no deemed disposition provision in the Income Tax Act for inventory properties used to produce business income. This means that inventory properties or assets utilized in an adventure in the nature of trade can pass to the deceased's estate tax-free. In that instance, tax would be due upon asset disposition.
Capital Property: Cryptocurrencies and NFTs
NFTs and digital currencies like Chainlink, Cardano, Polkadot, Ethereum, and Bitcoin can sometimes be considered capital assets, but this is not always the case. If their owners manage their cryptocurrency and NFT holdings in a way that is consistent with crypto trading and earning revenue for their business, the crypto assets may be regarded as inventory under the Income Tax Act. This means that whether bitcoin and NFTs are capital property in the context of deemed disposition upon death depends on whether the income derived from these assets during the life of the deceased is classified as capital gains or business income under the Income Tax Act.
The broad principles governing the distinction between income and capital gains are discussed here. Different applications of these parameters will be made for cryptocurrencies and NFTs. Consult a top Canadian crypto tax lawyer to determine how various common law income vs. capital gains characterization laws may apply to your cryptocurrency and NFT transactions.
Tax Deferral for NFTs and Cryptocurrencies Under Section 70(5)
If a person's cryptocurrency and NFT portfolio is found to be capital property that generates capital gains, estate crypto planning arrangements should be set up to delay the subsection 70(5) deemed disposition.
The taxpayer's estate and beneficiaries may wind up paying much more taxes than necessary as a result of market fluctuations if the subsection 70(5) tax is not postponed. Think about the scenarios listed below.
- At the time of his death, Howard had a portfolio of NFTs and cryptocurrencies valuing at around $500,000 with an adjusted cost base of $200,000. A deemed disposition and a deemed capital gain of $300,000 will both occur. Only a year and a half after his death, Howard's estate trustee was able to sell his cryptocurrency and NFT portfolio for $600,000, netting a $100,000 capital gain. The $100,000 capital gain from the actual disposition for the estate and the $300,000 capital gain from the deemed disposition are both taxed in Howard's estate.
- Sheila died with a cryptocurrency and NFT portfolio with an adjusted cost base of $200,000, valued at about $500,000 at the time of her death. A deemed disposition and a deemed capital gain of $300,000 will both occur. However, a year and a half after Sheila passed away, her estate trustee sold her cryptocurrency and NFT portfolio, but the market had fallen, and the portfolio was only sold for $400,000. Her estate must pay tax on the $300,000 capital gain that is deemed to have been disposed of on her death, but as the assets were deemed to have been acquired at the time of her death, there is nowhere for the $100,000 capital loss to be carried forward or back.
Canadian taxpayers should think about utilizing estate planning tools to defer the subsection 70(5) deemed disposition tax in order to prevent scenario 2. Below, we'll talk about three of these structures.
The Section 85 Rollover
A section 85 rollover enables eligible transferors to choose to transfer eligible property for a predetermined sum in concert with a transferee corporation. This agreed sum serves as both the starting point for calculating the transferee's tax expense of the property and the proceeds of disposition to the transferor.
By allowing the taxpayer to transfer the property for cost rather than having the transfer price treated as fair market value under section 69(1) of the Income Tax Act, this rollover provision enables the transferor to postpone all or a portion of the tax liability that would otherwise arise on such transfer to a corporation. Property ownership passes to the corporation, which is a taxpayer under the Income Tax Act and can survive the death of the transferor. However, as the holding corporation's shares will still be considered to have been disposed of, further estate planning from expert Canadian tax lawyers is necessary.
The Spousal Trust and Gift to Spouse
According to the Income Tax Act, a decedent can leave assets to his or her spouse or a spousal trust while deferring taxes. The only planning required is to make a will to that effect. When the spouse passes away and the property is deemed to have been disposed of in accordance with section 70(5) of the Income Tax Act, the benefit of tax deferral expires.
The benefits of tax deferral through gifts to a spouse or to a spousal trust can be restricted depending on the particular circumstances and expected lifespan of the spouses.
The Inter Vivos Trust
A trust established to hold the settlor's assets is known as an inter vivos trust. Similar to the rollover procedure outlined above, the settlor transfers his or her capital assets to the inter vivos trust, which then becomes the legal owner of the assets under the Income Tax Act and is exempt from the deemed disposition rule for whatever assets it retains. When the asset is vested into the inter vivos trust, the settlor must, unlike a qualified transferee corporation, pay any applicable capital gain taxes based on the asset's fair market value.
An inter vivos trust, on the other hand, offers a flexible structure for defining a class of beneficiaries, which could include the deceased's descendants. Contrary to shareholders in a corporation, beneficiaries in an inter vivos trust are not able to exercise their right to vote, allowing the trustee the discretion to allocate funds to the beneficiaries as they see fit.
It's crucial to be aware that a company can be the beneficiary of a trust and that a trust can be the shareholder of a corporation. This opens up a much more intricate and interesting estate planning techniques than the previous three that we covered. Depending on your particular tax planning requirements, our skilled Toronto crypto tax lawyers can assist you in combining the advantages of an inter vivos trust with rollover transactions.
Pro Tax Tip - Determine Your Cryptocurrency and NFT Characterization, as well as Your Tax Plan
Before thinking about estate planning transactions, make sure you conduct your due diligence regarding the tax characterization of your cryptocurrency and NFT assets. In addition to forming the basis for tax-strategizing your will to reduce taxes on death, a well-researched Canadian crypto tax memorandum drafted by experienced Canadian crypto tax lawyers can frequently serve as proof of such due diligence against future CRA tax reassessments beyond the normal tax reassessment period. Speak with one of our expert Canadian crypto tax lawyers that specialize in cryptocurrencies to develop a will tax preparation approach that meets your unique cryptocurrency assets status and reduces taxes upon death.
"This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a lawyer."