How does capital gains tax affect you?

It’s natural to speculate about rising tax rates with every government shift. Over the last few years, Canadians may have wondered whether they would see an increase in the capital gains inclusion rate. Taxpayers haven’t seen a hike (so far), but the current budget deficit has once again spotlighted the topic. 

Before we go any further: what are capital gains?
How does capital gains tax work in Canada?
Capital gains exemption on the sale of businesses
How to calculate capital gains or capital losses
Canadians don’t pay capital gains on their primary residence
Taxes on capital gains from the sale of a non-primary residence
How to avoid capital gains tax on rental property in Canada

Before we go any further: what are capital gains?

A capital gain (or loss) is the difference between the purchase and sale prices of an investment, capital asset or piece of property. A capital gain is only considered income when the asset is sold. If your capital gains are positive, you’ve made a profit that can be taxed. Capital gains (and losses) are generally associated with stocks and real estate investments because those prices generally increase (or have price volatility, at least). 

An asset needs to be sold to trigger a taxable event, meaning the gain (or loss) needs to be reported on your tax return, in most cases. When an investment’s value increases or decreases without being sold, these are referred to as unrealized gains and losses or “paper gains.” They should not be treated as a taxable event. One exception would be barter transactions, which are taxable.

If your capital gain is negative, you incur a loss and can often use this to offset gains. 

How does capital gains tax work in Canada? 

Only 50% of a capital gain (or loss) is included for tax purposes. This 50% is called the inclusion rate. Most investments in Canada are taxed at the 50% inclusion rate, which means that 50% of the capital gain is considered income for tax purposes, and the other 50% is tax-free. For example, if you made $200 on an investment, you would pay taxes on 50% of that, meaning $100 will be taxed on your next tax return. This cuts your tax rate in half for the item and is important for Canadians since all investments aren’t treated equally. 

For the last two decades, capital gains in Canada have been 50% taxable. It means that half of the capital gain is tax-free. This applies to non-registered investments, cottages, rental properties and some businesses and assets. 

If the capital gains inclusion rate increases, you may have a higher tax bill when selling an investment. This would include stocks, mutual funds, exchange-traded funds, rental properties, etc.

The thing with capital gains is that they are only taxable once realized and after a capital asset is sold. Intelligent investors may strategize selling investments to capitalize on tax opportunities. For example, they may sell loser investments to create a capital loss, which they can use against expiring capital gains declared 3 years ago. This is one example of tax planning.

Need help with your tax planning? Here are some considerations to think about. 

Capital gains exemption on the sale of your business

Everybody is entitled to a tax loophole that allows you to sell a business and not pay any capital gains tax on the sale — up to about $1,000,000. This is called the Lifetime Capital Gains Exemption, and it applies to qualified small businesses and qualified farm or fishing properties.

If you sold a qualifying property during the year and want to claim this exemption, you must complete the T657 - Calculation of Capital Gains Exemption form. You’ll need to know the following: 

• Proceeds of Disposition — This is the price you sold the qualified property for, AKA the total cash you received, less any disposal fees. 
• Adjusted Cost Base (ACB) — This is the total price you paid for the qualified property up to the point of selling it. 

Capital gains tax came into effect in 1972. If you owned the property you were selling before 1972, the ACB would equal the appraised value of the qualifying property in 1972.

Qualified Small Business Corporation (QSBC) shares are the most common example. If you were a shareholder in a Canadian small business and those shares were sold, this gain may be shielded from tax with your lifetime capital gains exemption (LCGE). These qualifications have complicated rules; please contact us for more details.

Have you used a portion of this exemption in the past? If so, only a portion of your lifetime limit may be available. If you need clarification, talk to us. 

How to calculate capital gains or capital losses

Therefore: Capital Gain (Loss) = (Selling Price - ACB) 
Capital Gain x Inclusion Rate = Taxable Capital Gain

Canadians don’t pay capital gains on their primary residence

Unlike the United States, the capital gains on a principal residence in Canada are not taxable, meaning they have an inclusion rate of 0%. According to the Canada Revenue Agency (CRA), this is generally true if: 

• Your home was your principal residence for all years you owned it or for all years except one year.
• You report the sale of the property and designate it as your principal residence on your tax return, Schedule 3 and complete Form T2091 (IND).
• You or a family member did not designate any other property as a principal residence while you owned your home.

Taxes on capital gains from the sale of a non-primary residence

A non-primary residence usually falls into two major categories: personal and business. If you own a few properties that aren’t your primary residence, they are considered investments. You are generally required to pay taxes on the gains from these properties at the 50% inclusion rate.

Whether incorporated or not, businesses that trade property have to pay a full rate. This includes flippers and other folks generating regular “business income” from the sale. Companies pay their business rate, and people pay the income tax rate. 

Home flippers beware: if you’re “moving” into a project and claiming it as your primary residence, the CRA has explicitly said this can void a primary residence exemption. If you do this, you risk the CRA flagging the activity and seeking back taxes.

If you’re surprised by a high tax bill, we can help you figure it out. 

How to avoid capital gains tax on rental property in Canada

When you sell a rental property, you could create taxable capital gains or losses. The capital gain or loss is the difference between the selling price (less selling costs) and the purchase price. If the property was ever your principal residence, only a portion of the capital gain would be taxable.

Here are five ways to help eliminate taxable capital gains on the sale of a rental property: 

1. Use capital losses to eliminate your capital gains

A capital loss happens when you lose money selling a property (you sold it for less than you bought it for). You can save these losses and apply them against future capital gains. 

• If you don’t have capital losses today but plan to incur them in the future, you can carry them back up to three years in the past. Please consult a tax professional to learn more. 
• Keep track of your assets and consider selling any that have declined in value. Doing so at the right time could significantly impact your tax bill. 

2. Time the sale of your property when your other sources of income are at their lowest. 

Think about your lifecycle and identify when the timing for these types of transactions is optimal. 

• If you own a corporation, you should consult your accountant about receiving a lower dividend or salary in a year when you incur significant capital gains. 
• If you or your spouse are about to go on parental leave, this may be another time your income is lower than usual. 

3. Hold your future investments in tax-advantaged accounts such as your TFSA or RRSP. 

These types of accounts are more shielded from taxes and are referred to as “registered accounts.” You can set one up at any Canadian financial institution. 

4. Donate property to causes that are meaningful to you. 

If you have assets (property or stocks), you can donate them to charity and use the donation to lower your capital gains tax. If these assets have grown significantly since you purchased them, you will not have to pay the capital gains tax. The catch is that you’ll usually get a donation tax credit as opposed to cash for the sale of your property. Please consult a tax professional before doing this. 

5. Make sure all capital expenses are tracked and included in the cost base (ACB) of the property. 

This includes renovations and general improvements. Consider doing some renovations before selling a rental property to ensure any costs you incur to sell (legal fees, realtor fees, etc.) are included in the ACB. 

Learn more about rental properties and rental property tax on our blog. 

Stress-free tax seasons are a thing 

At True North Accounting, we help small business owners set up a foundation for success and thrive. Book a meeting with one of our knowledgeable CPAs so we can get your taxes done on time and right and save you some money. There’s lots you can do and consider as you tax plan for next year. Let’s talk! 

Did you find this blog helpful? Read more about Personal Tax topics relevant to you and your small business.