A general rule for estates that are administered in Canada and paid to Canadian beneficiaries is that inherited money is not taxable. So if one of your relatives leaves you $100,000 in cash in their will, you don't have to pay tax on the $100,000.
Another general rule is that when there is a gift that gives rise to tax, the tax is paid by the estate. For example, let's look at what would happen if the $100,000 that was left to you was not held in cash, but was held in an RRSP. If you are the spouse of the deceased (or in limited circumstances, a disabled child of the deceased), the full $100,000 of the RRSP can roll over to you without you having to pay tax at the time it's rolled to you. The tax payment is deferred until you pass away or take the money out.
But if you are not the spouse of the deceased, then the tax situation is completely different. Everyone who has an RRSP knows that when the money goes in, it is not taxed. When it comes out, it's taxed. On estates, the law says that the deceased's RRSP is considered cashed out at the time of death. That means the tax has to be paid. Debts of an estate, including taxes, are normally paid out of the residue of an estate. For a beneficiary inheriting an RRSP this should mean that he or she gets the full value of the RRSP and the tax is paid by the estate. This assumes, of course, that there is actually enough money in the residue to pay it.
If there is not enough money in an estate to pay the tax arising on an RRSP, Canada Revenue Agency will pursue the individual who received the RRSP for the tax bill. This is because when you accept the funds from the RRSP, you also accept joint liability for the tax. CRA's policy is to collect from the estate first if possible, but as I said, that's not always possible. So this is an exception to the general rule that inherited money is not taxed.
The tax questions also arises with capital gains tax on real estate. If you inherit the house that was the deceased's principal residence, then there is no capital gains tax to worry about because a principal residence is exempt from it. But you might have been left the cottage or a revenue property or other real estate. On those properties, capital gains tax will arise. Normally this tax is paid from the residue of the estate, assuming there is cash enough to pay it. Unlike the RRSP situation, you are not liable for the tax in this situation. However, the duty of the executor is to use assets to pay taxes and debts first before beneficiaries receive their inheritance. This means that the cottage or revenue property might end up being sold to pay for those capital gains taxes. In a way, this means you've paid them personally simply because they were taken out of the gift you would otherwise receive.
Keep in mind that in particular circumstances, a beneficiary could be directly affected by tax arising from the gift. So far we have just talked about general rules that apply where the will itself doesn't say anything beyond the usual "pay my debts from my estate". The wording of a will can make a big difference. In some wills, the deceased will state that each person who inherits something under the will (such as a cottage or an RRSP) has to pay the tax on his or her own inheritance, instead of the estate paying it. That is perfectly legal, though it is not done very often.
Another important note about estate money is that the fees taken by an executor for his or her work on the estate are taxable. They must be included as earned income on the executor's personal income tax return.
Estate taxes are tricky. Executors should be careful and consult accountants or estate lawyers if things get complicated.
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