What are capital gains?
Investing can yield a very healthy income. But, along with that generated income comes capital gains tax.
What are capital gains? According to Investopedia, a capital gain is “an increase in a capital asset’s value and is considered to be realized when the asset is sold.”
The Canada Revenue Agency (CRA) charges a tax on any asset or investment that you sell for a profit. When charged with capital gains, a percentage of the difference between the purchase and sale price is added to the income you made. Capital gains taxes are most commonly associated with real estate, however, they are also charged with a wide variety of investments and the resulting income.
What are capital losses?
While capital gains represent income generated from an investment, capital losses are the difference between the lower selling price and the original higher purchase price. As Investopedia explains, a capital loss is “a loss incurred when a capital asset is sold for less than the price it was purchased for.”
At tax time, you can use capital losses against any capital gains to reduce your taxable amount for that tax year. The Canadian government allows you to offset your capital gains with your capital losses for up to three years, after claiming capital gains.
How are capital gains calculated?
The capital gains tax is the same for everyone in Canada — currently 50%. So, for example, if you buy a stock at $100, and it earns $50 in value when you sell it, the total capital gain amount is $50. You would pay the marginal tax rate on the $50 capital gain — in this case, $25.
Want to get an idea of what your capital gains tax looks like on the sale of a property? A capital gains calculator can help you figure it out.
How to avoid capital gains tax in Canada
Capital gains tax applies to all income generated from investments. Generally speaking, the only way to avoid paying capital gains tax in Canada is if something tragic (death) or terrible (you are broke) happens. However, there is a way to mitigate or reduce the amount you pay.
Dividing up the sale of your assets has a significant impact on capital gains owing. If you plan on selling a number of properties or investments, hold off until the new year. This way, the income shifts to the following tax year. This also reduces your taxable income for the current year.
If your income varies year-over-year, it is also possible to offset a capital gains claim until a year where you make less money. By doing this, you face lower taxes and keep more of the capital gains earned from selling your investment.
If you want to hold onto the assets of the investment, consider gifting the asset to an organization or a person. Keep in mind, though, these aren’t equally appealing.
If you gift stock as a donation, you’ll get a tax receipt and avoid the capital gains tax in Canada. And while this is one option, it’s important to note that the actual investment is no longer yours. Gifting it to a family member is also an option, but this functions more like tax deferral to someone else, instead of actual tax avoidance.
Lifetime Capital Gains Exemption (LCGE)
If you are a business owner in Canada or operate a farm or a fishery, you can benefit from the Lifetime Capital Gains Exemption. The amount of the exemption changes annually, however, it is currently close to $1 million. To clarify, business owners in Canada who mainly do business here can reduce capital gains by the exemption amount when selling a business or property.
Are dividends considered capital gains?
Investing in dividend stocks means benefitting from a payout a few times a year. Dividend stocks are taxed, but not the same way as capital gains. Instead, it’s at a lower rate. You only pay capital gains on investments you sell. In the case of a dividend, a company is paying you that benefit — depending on the type of stock. Dividends are paid based on business profits. These are, in turn, passed to you. They are, however, added to your income and taxed accordingly. You won’t get hit with the hefty capital gains tax, but the income is taxed at a lower rate.
Claiming a capital gains reserve
Not all purchases are paid for in full on the sale of an asset. There are instances where, let’s say, you pay out a portion of a sale in year one. Then, you pay off the remainder over a number of years. In these cases, the CRA may allow a Capital Gains Reserve claim. With this option, you claim the portion of the sale paid in that year, rather than the entirety of the sale price at once.
What is are the ‘superficial loss’ rules?
Superficial loss rules are for situations where someone tries circumventing capital gains tax by selling an asset, claiming a loss, and then buying it back right away. To clarify, the CRA created it to deal with anyone trying to cheat the system. The rule states that, if you sell and repurchase the exact same investment within 30 days, you can’t claim a capital loss.
These rules also apply if you sell a property, for example, and a family member purchases the exact same property from you within those 30 days.
Tips for managing the superficial loss rules
Savvy investors have a workaround to avoid the ding of the superficial loss rule. Let’s say you invest in an asset that tracks the S&P 500 index. Simply sell that asset, and find another investment product tracking a similar index.
In addition, consider taking advantage of the opportunity to engage in tax-loss harvesting. This involves offloading underperforming funds, creating a capital loss. Apply this loss to your gain to offset the impact.
You can also mitigate the impact of capital gains tax by donating assets from the gain to charity. When you donate to charity, you receive a tax benefit. And this benefit applies to the gain, reducing the amount owing. Furthermore, the donation is in the form of a transfer of ownership of the stocks, rather than in cash, acting as a portfolio rebalance. This helps mitigate the gains, with the loss of having fewer stocks earning money in your portfolio.
Finally, you always have the option of holding off on reporting the loss until next year’s taxes. This method of reducing capital gains is a bit more tricky. The government requires that you report both gains and losses if you incur both in the same tax year. If, however, you only incur losses, carry them over until such time (within the next three years) that you have gains to help offset the loss.
Capital gains tax in Canada
There are a few certainties in life: death and taxes — including capital gains tax on the sale of an asset. In other countries, there may be some tips and tricks and loopholes to mitigate the hit. But in Canada, if you make money off of an asset, you pay capital gains tax on it. Your best bet? Talking to a financial professional to help you legally, and effectively mitigate the impact of capital gains.