The capital gains tax in Canada proves once again that there’s just no escaping taxes. The old adage is right: paying taxes is one of the two ineluctable things in life.
Not only do you have to pay tax on your employment income, but you also have to pay tax on any investment income, that is, capital gains tax (in Canada and just about anywhere else, really).
So while investing can certainly be a good way to generate a healthy income – which is cause for celebration – you have to pay some painful tax on that income. And that can be a source of dread and anxiety: that capital gains tax that takes such a big bite out of your investment income in Canada.
You can, however, beat the taxman to a degree . . . if you know how.
First, you need an understanding of the tax and its functioning. Then you’ll need to know about the strategies to minimize your capital gains tax bill. And it never hurts to have some professional tax guidance along the way.
So let’s get started . . .
Overview of Capital Gains Tax (Canada)
What is the Capital Gains Tax?
In the broadest terms, the capital gains tax in Canada is tax levied on investment-generated income, or capital gains. Any time you sell an asset or investment for a profit, you have a capital gain, and the Canadian Revenue Agency (CRA) charges a tax on that.
With a positive difference between purchase price and sale price, you have a profit that adds to your income and is liable to the capital gains tax in Canada. Most commonly, this tax is associated with real estate, but is applicable to a range of investments and the income that results from them.
More specifically regarding the capital gains tax in Canada, “[w]hen you sell investments or real estate holdings for more than you paid, with a portion of the difference being added to your regular income, you have to declare the additional income as a capital gain. You are then taxed on a percentage (referred to as the inclusion rate) of that gain. The inclusion rate for the capital gains tax is the same for everyone, but the amount of tax you pay depends on your total income, personal situation and your province of residence.”
What is the Capital Gains Tax Rate in Canada?
The capital gains tax rate in Canada is 50% of any relevant capital gains. But that’s not as simple as it sounds on the face of it.
If you dig around in the Income Tax Act, you’ll be hard pressed to find specific references to “capital gains tax.” The reason for this is that there is no special tax for gains or profit made from investments and/or real estate. Rather, the capital gains become part of your income, and you pay the tax as an additional part of your income – which makes it, on a strict view, an income tax.
When you sell an asset/investment for more than you paid for it in Canada, you have a capital gain, 50% of which is taxable. But then that 50% of the capital gain is added to, or included in, your income, hence the term “inclusion rate.” “This means the amount of additional tax you actually pay will vary depending on how much you’re making and what other sources of income you have.”
This inclusion rate is universal across all provinces. But the amount of tax you have to pay is also based on your marginal tax rate. So if you have a lower marginal tax rate, you’ll wind up paying less in overall capital gains tax in Canada.
The upshot here is that it’s not as straightforward as it at first seems.
Capital Gains vs. Capital Losses
Another thing to keep in mind is the distinction between capital gains and capital losses.
A capital gain is, as we’ve shown, “an increase in the value of an investment (such as stocks or shares in a mutual fund or exchange traded fund) or real estate holding from the original purchase price. If the value of the asset increases, you have a capital gain and you need to pay tax on it”
And, then, there’s the difference between realized and unrealized capital gains (which we’ve lightly touched on). When you sell an investment or real estate and make a profit, you have a realized capital gain – and you have to pay tax on it. An unrealized capital gain occurs when investment increases in value, but you haven’t sold it. In this case, you don’t pay a capital gains tax.
This has some important implications for how you can reduce your tax bill.
A capital loss, on the other hand, happens when your investment/real estate decreases in value (compared to what you originally paid for it). The important thing to keep in mind here is that capital losses can be used to offset or reduce the total tax you have to pay.
Keep these things in mind because they have some important implications for how you can reduce your capital gains tax bill in Canada. In fact, capital losses can be carried back by three years and even forward.
How to Calculate Capital Gains Tax (Canada)
The first step here is to determine the adjusted cost base to find out whether you’ve made or lost money on investments.
To calculate the adjusted cost base, start with the book value – the original purchase price of your investment(s) – making sure to include acquisition costs such as fees. Then, subtract the book value plus fees from the amount you sold your investment(s) for. This difference between sale price and adjusted cost base will yield the capital gains subject to tax.
Typically, your financial institution(s) will track the adjusted cost base and capital gains for you. You can, however, calculate it yourself.
How to Manage Capital Gains
Now let’s look at some strategies to help you reduce or even avoid your capital gains tax in Canada . . .
Timing It Right
Your capital gains tax rate on the 50% of gains is, as we pointed out earlier, determined by your marginal tax rate (which, remember, is impacted by your provincial tax rate). And the less money you make, the lower your marginal tax rate, and the less you pay in taxes.
You have a couple of possible options, then, when it comes to managing capital gains tax . . .
“For instance, if you have an investment property you want to sell, time the sale of that property for soon after January 1 in any given year. Because capital gains tax is owed in the calendar year in which a property is sold, that gives you 16 months before you owe tax on those earnings (in April of the following year).”
Another possible course is to sell an investment/asset during a year when you know your other earnings will be low. This has particular application for small-business owners who can take advantage of it in years when business expenses are especially high (which means more deductions).
Another strategy is to defer earnings on the sale of investments/assets, a strategy known as the Capital Gains Reserve. You owe tax only on earnings actually received. Here’s how it works . . .
“Assume your annual earnings are $50,000 and the sale of a property earns you $100,000 in profit. Without deferring the earnings, you’d owe approximately $24,480 in taxes in the first year (recognizing your earnings plus the full capital gain in that first year) and about $8,000 in tax each year after, for a total tax hit of $48,480.
“If, however, you asked the buyer to stagger payments so that you only received $25,000 in each of the next four years, the total tax bill would be approximately $46,820—resulting in a tax savings of $1,660. It doesn’t sound like a lot, but when you apply actual deductions, such as RRSP contributions, charitable donations, and self-employment expenses, the tax savings can really add up.”
Creating Losses and Tax Deductions
Another way to reduce the amount of capital gains tax you owe is to “seek out and trigger capital losses or find and claim tax deductions.”
You could, for example, sell stocks or assets at a loss, though assets have to be sold at fair market value. You could also utilize tax shelters such as making a larger RRSP contribution.
Utilizing the Lifetime Capital Gains Exemption
The CRA offers a lifetime capital gains exemption to reduce the tax burden and encourage growth of small business. If you own a qualifying kind of business, one that has been profitable, you can, on retirement, sell or gift the business and escape the capital gains tax (in Canada).
Do be aware, though, that there is a cap and some pretty strict qualifying rules.
Giving It Away
You can also avoid paying capital gains tax on an asset by giving it away, like this . . .
“Rather than selling an asset, paying capital gains tax on the earnings and then using those earnings to make charitable donations, consider donating the asset instead.
“For example, if you plan to make a $1,000 donation to a charity, donate stock with a market value of $1,000 (but which cost you less to purchase). Making the donation in stock entitles you to the $1,000 charitable receipt for tax purposes, while not triggering capital gains tax.”
Keep in mind, though, that these tax benefits don’t apply when you gift an asset to a family member. In this case, the gift counts as “a taxable disposition which triggers capital gains tax.”
A Final Caveat
With respect to capital gains tax in Canada, the advice heard most often is this: “Be sure to talk to your tax advisor about any capital gains tax strategy before you attempt to implement it. Taxes should never lead a personal finance decision; rather, tax strategies should be a contributing factor to each decision. Be sure you know the advantages and disadvantages before setting any strategy in motion.”
Many people run afoul of the CRA simply through inadvertence. For example, real estate investors often falsely assume that they can tax shelter profit from the sale of a property by claiming it as a principal residence. But if the strict CRA guidelines aren’t met in this scenario, the property can’t be claimed as a principal residence.
So what does this all mean?
It means that the whole matter of capital gains tax in Canada, as well as managing capital gains, is a complex affair, one that calls for an accounting firm that isn’t the typical stuffy firm. Nope. When it comes to capital gains tax, you need a firm that manages personal and corporate taxes utilizing the latest technology – educating and inspiring people and companies to use their finances to their advantage, emphasizing growth over mere accounting.
And that’s exactly what Envolta is.