Taxes are never simple, but when it comes to capital gains tax, general understanding among Canadians is particularly low.
So we’re here to look at the key information you need to know to file your taxes properly while being as financially efficient as possible.
What is a Capital Gain?
Let’s start with the basics: a capital gain is an increase in the value of an investment.
This investment could be stocks, bonds, property, mutual funds, or something similar.
Any investment that isn’t tax-sheltered is subject to capital gains tax.
The gain is the difference between what you paid for the investment, including fees and expenses incurred when acquiring the asset, and what it is worth now – its current value.
That difference (when positive) is subject to taxation.
However – and this is an important distinction – you only pay tax on realized capital gains.
You realize the gains when you cash out of the investment (for example, sell the property that has gained value).
But if you hold onto the investment, the gains are unrealized; the value of the investment could change in the future, and so you pay no tax until you sell.
What is a Capital Loss?
Just as a rise in the value of an investment can lead to a capital gain, a fall in the value of an investment can lead to a capital loss.
If the value of the asset at the time of sale is lower than the total amount it cost to purchase it (known as the adjusted cost base – the price of the investment plus all expenses, fees, commission and so on), you have a realized capial loss which must be taken into account in your taxes.
What is the Capital Gains Inclusion Rate?
So now you have an idea about what capital gains are, and when capital gains taxes occur.
So far, so good.
But things are about to get more complicated, because capital gains tax isn’t applied to every dollar of capital gains you realize.
The inclusion rate is the percentage of your gains that are subject to tax.
The inclusion rate has varied over time (see graph below).
As of 2021, it stands at 50%.
So, if you make $1,000 in capital gains on an investment, you will pay capital gains tax on $500 of it, and no tax on the other $500.
Some political parties are advocating for a change in this rate in the future.
How to Calculate Capital Gains Tax in Canada?
So how much tax will you have to pay? That’s the next big question, and it depends on a lot of factors – including any capital losses, your income level, your tax deductions, and so on.
The easiest way to think of it is to consider your net taxable capital gains as a secondary source of income, which raises your overall income level and affects your tax burden accordingly.
This is probably best illustrated with an example:
Last year he sold it for $500,000.
That’s a pretty sweet capital gain of $250,000!
We know from above that the inclusion rate is 50%, so on his next taxes, Sam will have to pay tax on half of his capital gain, or 50% x $250,000 = $125,000.
This is his taxable amount of capital gain.
Luckily for Sam, he had no other investments that were divested last year, so he has no other capital gains and no capital losses to take into account.
This leaves his net taxable capital gain at $125,000.
Sam is employed and earns a salary of $80,000 a year.
His net taxable capital gain of $125,000 is effectively added to this amount, and his taxable income for the year becomes $80,000 + $125,000 = $205,000.
His tax rate on this income is calculated in exactly the same way all income tax is calculated by the CRA, using federal income tax rates.
What about something more complicated? Let’s look at a messier set of circumstances, involving a capital loss:
This year she divested herself from part of her stock holdings.
To work out her tax bill, let’s look at exactly what she did:
a. PurchaseBarb bought 100 shares of A Company for $20 each.
She also paid a $25 commission to the broker who arranged the purchase.
Her total cost for the shares is therefore (100 x $20) + $25 = $2,025.
This can also be looked at on a per share basis: she paid $2,025 for 100 shares, making the adjusted cost base $20.25 per share.
b. SaleBarb sells half of her shares when their value drops to $10.
This means she sells 50 shares, for 50 x $10 = $500.
She also pays a broker fee for this transaction, of $25.
She therefore gets back just $475, or $475 / 50 = $9.50 per share. She keeps the other half of the shares, so their loss is unrealized and has no effect on her taxes.
c. Realized Capital LossBarb effectively spent $20.25 x 50 = $1012.50 for the block of shares in question, and got back $9.50 x 50 = $475. That’s a capital loss of $1012.50 – $475 = $537.50.
How to Avoid Capital Gains Tax?
1. Timing Your Sale
Being smart about when you divest yourself from investments can be a powerful way to reduce your overall tax bill.
For example, if you know you have already made a capital gain in one year, consider putting off the sale of another successful investment until the next year.
This spreads your capital gains out and reduces your effective tax rate each year.
Or, if your income fluctuates, pick a lower earning year to sell investments, so your overall taxable income stays as low as possible.
2. Transfer Ownership
Another smart move is to transfer ownership of an asset to a loved one, but pick your moment.
If you choose to transfer ownership while the asset is in the red (i.e. would trigger capital gains loss), this means you can apply the loss to other investment successes, while your loved one gets to hold onto the asset, which may well appreciate in the future.
3. Deferring Gains/Losses
Capital gains and losses do not have to be dealt with in the tax year immediately following the year they are realized.
The CRA allows taxpayers to defer their capital gains tax burden by up to three years – meaning you can defer either your losses or your gains to years when it will have the most impact on your taxes.
This is very helpful, as capital losses can be used to offset capital gains, and so lower your overall tax burden.
4. Donate to Charity
Charitable donations are tax deductible, and donations do not have to be cash.
You can donate an asset to charity (known as an in-kind donation), and you will receive a tax receipt for the current fair market value of that asset.
This means that if you have an asset that has appreciated, you can donate it, avoid paying capital gains on it, and receive a tax deduction for the full amount.
5. Utilize Tax-Free Accounts
Using registered, tax-sheltered accounts like TFSAs, RRPs, RRSPs and RESPs is an efficient way to hold investments without having to worry about extra taxes.
And if you can prioritize holding higher-earning investments in these vehicles, even better.
While it is both legal and prudent to use the tax code to lessen your financial burdens, the letter of the law is clear and must be followed. Simply not paying for or registering your capital gains with the CRA is illegal.
Frequently Asked Questions
- Who has to pay capital gains tax in Canada?
Anyone filing taxes in Canada who has made a qualifying capital gain.
- What types of assets are considered capital property and subject to capital gains tax?
Stocks, bonds, mutual funds, land, property other than your primary residence, cottages, equipment and other investments are all subject to capital gains tax. Only registered investments in government-approved tax-sheltered vehicles are not.
- Are gifts to family members taxable?
Yes. Transferring the ownership of an investment to a family member counts as disposition of that investment, and so the gift becomes subject to capital gains tax.
- What is exempt from capital gains tax?
There are a couple of exemptions from capital gains tax. This includes primary residences, and something known as the lifetime capital gains exemption, which applies to qualified small business shares, qualified farm properties, and qualified fishing properties.
- Do I have to pay capital gains tax on my house?
No. Primary residences are exempt from capital gains tax; you do still have to report the sale of your home on your taxes, but if you lived in the home the entire time, you qualify for the primary residence deduction and so your effective capital gains taxable amount for that property falls to zero.
- How do I calculate capital gains on foreign assets?
Foreign assets can quickly become complicated, but the important thing to note is that you must convert everything into Canadian dollars, and you must use the exchange rate from the time of action to do so. So the exchange rate from when you invested may differ quite a bit from when you divested, but you must find out both and use them appropriately to calculate the equivalent values in CAD.
- Can I split capital gains with my spouse to reduce my taxes?
No. Capital gains and losses cannot be transferred between spousal tax returns. However, if you purchase an investment jointly with a spouse, then the capital gains upon sale can be split between you.
- What’s the difference between capital gains tax and business income?
Business income is taxed separately to capital gains, at 100% rather than 50%. This is especially salient for those who have rental or investment properties, as gains from doing this counts as business income, and not capital gains.