Tax and other pitfalls await when you inherit real estate

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Many seniors own homes, cottages or rental properties and upon their death these assets will make up part of their estate. Their children may be wondering what to do with inherited real estate, whether they are engaging in pre-planning collaboratively with their parents or once they become beneficiaries.

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As a starting point, it may be helpful for parents and children to understand what happens to real estate when someone dies and someone else inherits it. There may be tax, probate and other implications that range from minimal to significant.

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Upon someone’s death, the tax implications depend upon who inherits their assets. When a spouse inherits, assets can be made over on a tax deferred basis. When someone other than a spouse inherits, there are tax implications.

Real estate is deemed to be sold at the fair market value at the time of the owner’s death. In the case of a principal residence, the proceeds may be tax-free if the owner did not own another property that was claimed as their principal residence during any years their home was owned. A cottage or rental property will generally have capital gains tax calculated based on the fair market value minus the original acquisition cost and renovations. A rental property may also be subject to a recapture of depreciation deducted against past rental income.

Real estate is also generally subject to probate or estate administration tax before an executor of a will can transfer the property or sell and distribute the cash proceeds from the property to a beneficiary. This can range from hundreds of dollars to tens of thousands of dollars, depending on the province and the property value.

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Some parents try to avoid capital gains tax or probate by adding a child’s name to a property and making it joint with right of survivorship. This will not avoid capital gains tax. Tax may be partially triggered when a child’s name is added if this is considered a gift of 50 per cent of the property value at that time. The fact that no money changes hands does not avoid a deemed disposition at the fair market value.

If beneficial ownership is not deemed to change when the child’s name is added, and no capital gain is reported by the parent, a full capital gain will instead be triggered upon their death. Probate may also be payable if the beneficial ownership of the property remains with the parent. Professional income tax and estate law advice should be sought around any joint ownership planning.

If an inherited property has a mortgage, most mortgages are eligible to be assumed by a new owner, including a beneficiary. A lender must approve the new borrower though, so if their income is insufficient, or their creditworthiness is not good enough, the property may need to be sold. Alternatively, the mortgage may need to be reduced by paying it down with other assets to satisfy the lender.

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If a property has a tenant, the estate becomes the new landlord upon the death of the owner. The lease terms will generally survive the death and continue to apply. If the property is to be sold, the tenant’s rights will vary by province, but the owner’s death will not circumvent them. A beneficiary may be able to receive their inheritance as a transfer of the property itself and take over as the new landlord for the tenant, and once again, the tenant’s rights will generally carry over to the beneficiary as well.

My advice to a beneficiary who inherits real estate or any asset for that matter is to focus on the value of that asset. If you had an equivalent amount of money in a bank account, would you buy that same asset? If the answer is no, you should probably consider turning it into cash by selling it. There are of course exceptions, but this can be a good test. All tax is payable by the estate of the deceased, so there is no tax advantage to keeping the asset. There may be costs involved to sell it, but those costs will apply in the future as well.

If you would otherwise use a million dollars in the bank to buy a million-dollar real estate property, and would buy that same property, perhaps it is worth holding onto after inheriting it. This is more likely to apply to a sentimental property such as a cottage or farm that you will use personally in the future. A family home may have a sentimental aspect to it as well. But if your goal is to keep an inherited property like your childhood home and convert it to a rental property, the likelihood of that specific property being an ideal rental property, especially for an inexperienced landlord, seems low.

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Recency bias still lingers for many Canadians after a long, strong period of growth for home prices. Many still feel real estate is the best wealth builder. The aggregate composite home price has tripled over the past 20 years nationwide as of Dec. 31, 2024, such that $100 of real estate has grown to $298. That stat on its own sounds like a compelling reason to keep real estate after inheriting it.

But the same $100 invested in the S&P/TSX Composite index over that 20-year period would have grown to $473. If invested in the S&P 500, $100 would have turned into $858.

In fairness, there have been regional differences in price appreciation, with some cities seeing growth more comparable to stock market returns. Real estate can also be leveraged, borrowing with a mortgage at an interest rate that is lower than the property growth rate, thus magnifying returns.

A rental property investor earning rental income in addition to property price appreciation would have also closed the gap on stocks. And most stock market investors would have earned less due to investment fees and because of having exposure to cash and bonds as well as stocks. But the point is a portfolio of North American stocks would have outperformed Canadian real estate with less work required and more liquidity over the past 20 years.

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Interestingly, Canadian real estate price appreciation over the past 20 years has been comparable to the 50-year growth rate. But both Canadian and U.S. stocks underperformed their 50-year returns by about two per cent each. As with all historical financial data, past performance is no guarantee of future results. And both stocks and real estate are likely to have lower returns in the future than the past 50 years, which included a much higher inflation environment in the 1970s and 1980s than we have now or are likely to have in the future.

Another consideration with inherited real estate is the composition of your own assets. If you inherit a home in Calgary, and you already own a condo in Calgary, keeping the inherited property could cause your net worth to be overly exposed to one city’s real estate market.

If you have registered retirement savings plan (RRSP) or tax-free savings account (TFSA) room, you could benefit from selling an inherited property and using the available cash to contribute to these accounts. The RRSP deductions would save you tax up-front, and that tax could be 50 per cent of your contributions, or more depending on your income and province of residence. TFSA income and capital appreciation is tax-free, whereas only a principal residence’s growth is tax-free, with rental income taxable annually and rental property or cottage price appreciation taxable on its sale.

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If real estate selling costs are causing hesitation, this is understandable. These costs can be five per cent of the property value or more. However, that is a short-run cost. In the long run, if you sold and only got 95 cents on the dollar you would only need to earn a 0.2 per cent higher rate of return from whatever you invested in to be in the same position after 25 years. If you can do it in a tax preferred account such as a TFSA or RRSP, you could earn an even lower rate of return, and still come out ahead.

Holding real estate after you inherit it does not save tax. The tax implications of inheriting from anyone other than a spouse are triggered upon the owner’s death. There can be sentimental reasons to keep inherited real estate, but unless you plan to use the property personally, you should ask yourself whether you would buy that real estate with an equivalent amount of cash. And while real estate is expensive to sell, and prices have appreciated significantly over the past 20 years, there may be simpler, more diversified, and potentially better, more tax efficient ways to invest the proceeds.

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As a reminder, I may be a certified financial planner but I do not sell investments so I have no skin in the game. I just think it is important for beneficiaries of inherited real estate to keep a property on purpose rather than by default, and reflect on some of these considerations.

Jason Heath is a fee-only, advice-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever. He can be reached at jheath@objectivecfp.com.

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