Insurance is complex enough – what happens when it intersects with our tax system?
We have good news…
Under the Excise Tax Act, insurance is a financial service, making it exempt from GST. If we only had to address the GST, this would be a simple, short article. However…
And we have bad news!
The interaction of insurance with the income tax system is not as straightforward. Various types of insurance carry different, sometimes surprising, income tax implications. Two broad-based questions arise:
- Is tax relief available for insurance premiums?
- Do insurance benefits attract an income tax cost?
A third issue arises when employers provide insurance to employees – do employees pay taxes on these benefits?
The income tax implications of property insurance typically align with the other income tax issues related to that property. Insurance is a cost of owning property. As such, if the property is used for personal enjoyment (e.g. a home, vacation property or personal vehicle), the premiums are also personal and generate no tax relief. However, if the property is used to generate income (e.g. a rental property, business premises or a vehicle used to earn income), the premiums are deductible from that source of income. Some property has mixed use (e.g. real estate with mixed rental and personal use, or a personal vehicle sometimes driven for business). The insurance (like the other costs) must be apportioned between income-earning and personal use (e.g. based on time used personally versus for rental; based on business and personal distance driven).
… an individual cannot claim medical expenses under the Medical Expense Tax Credit (METC) if they are reimbursed for those expenses.If the property is damaged, related insurance benefits will offset the costs of repairs. The insurance proceeds will be taxable or non-taxable on the same basis as the repairs themselves. But what if the property is not repaired? The insurance proceeds would generally reduce the cost of the underlying property because part of the property was “disposed of”.
If the property was destroyed, the insurance proceeds are the sale proceeds. Again, the tax treatment will follow the nature of the property. Where the proceeds exceed the property’s cost, a capital gain will result. This may mean taxes are payable, even if the property was used entirely for personal use. This might happen where a building is insured at its replacement cost, which is greater than its original purchase price. The proceeds could mean a significant gain, especially if the property has appreciated over many years of ownership.
Where the property is replaced, generally one can elect to apply the “replacement property” provisions of the Income Tax Act. Basically, so long as the policy holder spends the full insurance proceeds on replacing the destroyed (or stolen) property, they can apply any gains to reduce the cost of the new property. This means they do not have to pay taxes on the insurance payout. The policy holder must acquire the replacement property within two tax years after the year of the final determination of the insurance proceeds. The final determination of insurance proceeds is often done in the same year in which the property is destroyed. But in some cases, it may be many years later. This might occur because of a lengthy adjustment process. Or it could be because of a dispute that goes before the courts.
The gains may also be exempt due to the principal residence exemption. This requires reporting the disposition and designating the property as the owner’s principal residence. Remember not to overlook this when rebuilding, rather than selling, the home.
Ouch – that hurt!
We often purchase insurance to mitigate the costs of injury or disability. This covers a broad array of insurance products.
Insurance that covers medical (including dental) costs attracts no direct income tax costs. However, an individual cannot claim medical expenses under the Medical Expense Tax Credit (METC) if they are reimbursed for those expenses. The insurance premiums are generally eligible medical expenses, and can be included for METC purposes. Out of-pocket medical expenses must be significant to generate any tax benefit – only costs over 3% of the individual’s net income (capped at $2,397 for 2020 and $2,421 for 2021, with annual adjustments for inflation) generate any credit. When calculating the METC, remember not to overlook costs such as an employee’s share of premiums paid through employment (premiums payments by the employer are generally not taxable) or premiums paid for out-of-country coverage.
I’m off sick!
Many individuals have “disability insurance”, perhaps more accurately described as “income replacement insurance”. This insurance pays benefits if the individual is unable to work due to illness or injury. Many employers provide such coverage. The tax implications of this coverage can vary markedly.
… benefits paid from a life insurance policy as a consequence of the death of the insured are not taxable.The first question to ask is whether the insurance benefits are paid in a lump sum or periodically. Lump-sum benefits are not taxable. Periodic benefits – usually a percentage of the income the individual would have earned had they continued working – are much more common.
Where the employee pays the full premium (commonly referred to as an “employee-pay-all” plan), the benefits are non-taxable. Typically, such coverage pays benefits considerably lower than the employee’s normal income, reflecting their tax-free nature. No tax relief is available for the premiums.
Where the employer pays any part of the premiums, all periodic benefits are taxable to the employee. Normally, the insurance company issues a T4A slip, making both the employee and CRA aware of these amounts. The employer-paid premiums are not a taxable benefit. Premiums paid by the employee generate no tax relief when paid. However, the recipient of benefits can reduce their taxable benefits received by deducting the amount of the premiums they have paid. That sounds simple, but if neither the employee nor the employer has maintained a record of these premiums, re-creating these records can be challenging.
A relatively new product called critical illness insurance has largely escaped the attention of the tax system. These policies normally pay a fixed amount where the insured individual is diagnosed with certain conditions defined in the policy (cancer and heart disease are common conditions included). The Canada Revenue Agency (CRA) has noted that nothing makes benefits received under these plans taxable. Similarly, no tax relief applies to the premiums paid. Employer-paid premiums would be taxable to the employee.
Death and taxes
The cliché “two certainties” collide when we consider life insurance. Often, the tax answers here are simple – benefits paid from a life insurance policy as a consequence of the death of the insured are not taxable. Similarly, the premiums generate no tax relief. Interest paid on the death benefit is taxable and is typically reported on a T5 slip. Where an employer pays for life insurance coverage, the premiums are taxable to the employee.
Many individuals have “disability insurance”, perhaps more accurately described as “income replacement insurance”.Unfortunately, little in the tax system is this simple. In limited circumstances, premiums can be tax-deductible, but the requirements are complex. Put simply, the policy holder must assign the policy to a lender as required collateral for a loan and use the borrowed funds to earn income. This might include borrowings invested in a securities portfolio, a rental property or a business. The premiums are only deductible to the extent of the loan. For example, no more than two thirds of the premiums could be deductible for a policy with a death benefit of $750,000 used as collateral for a $500,000 loan. Other complexities exist, especially where the insurance policy goes beyond simple term insurance.
The life insurance industry has created many products that blend insurance coverage with investment objectives. Tax law restricts the extent of any investment component, and the life insurance companies are careful to stay within these limits. Often, the insured can cash out these policies during their lifetime. A portion of the proceeds may be taxable income. The insurance issuer will calculate the “adjusted cost basis” (ACB) of the policy (basically, premiums paid less mortality risks covered to date). Any cash received from the policy in excess of its ACB is taxable. Many individuals have been surprised to receive a T5 slip for this income, believing that they had received a tax-free insurance payout, or had realized a capital gain, which is only partially taxable.
Some policies allow “policy loans”. These can result in taxable income to the extent that the loans exceed the ACB. If the policy holder repays the loan, a deduction can be available, reversing previous income inclusions. However, no deduction is available where the loan is repaid from amounts payable on the death of the insured. In short, the loan must be repaid during the insured’s life for a deduction to be available.
As the above makes clear, many complexities can arise when insurance meets income tax. While this article has discussed some of the more basic issues, qualified professionals should review specific situations, as other complexities can arise.
The information in this article was correct at time of publishing. The law may have changed since then. The views expressed in this article are those of the author and do not necessarily reflect the views of LawNow or the Centre for Public Legal Education Alberta.
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