What is Capital Gains Tax and How is it Calculated?
If you’re investing in any type of capital property in Canada, such as individual stocks, or real estate, it’s important to have a basic understanding of the capital gains tax. In order to manage your investment properly, you’ll want to know how the tax on capital gains is calculated, in order to make the best investment decisions for your situation.
Capital Gains Tax Explained
Simply put, anytime you sell a capital property or investment for more than you paid for it, it triggers a capital gain, which you must pay income tax on. As I’ll cover in more detail later, a capital gain represents the increase in market value of your investment.
Examples of capital property would be real estate, or individual stocks and mutual funds held in a non-registered investment account. Some assets are exempt from the capital gains tax, such as your primary residence, or investment funds held inside of a tax shelter ie. TFSA or RRSP.
Securities that incur capital gains, such as an individual stock or mutual fund, are actually considered more tax-efficient than investments that produce interest income. That’s because you pay tax on 100% of earned interest, while only 50% of a capital gain is subject to income tax. Term deposits and GICs are examples of investments that pay interest income.
How are Capital Gains Taxed in Canada?
Wondering how capital gains tax is calculated? In Canada, investors pay tax on 50% of a capital gain. For example, if you sold an investment that had a $50,000 capital gain, 50%,or $25,000, would be added to your earned income for that tax year. The capital gain tax rate on $25,000 is simply your marginal tax rate. If your marginal tax rate was 30%, you would end up paying $7500 tax on the original capital gain of $50,000.
How Do I Calculate My Capital Gain?
Calculating a capital gain isn’t quite as simple as subtracting the purchase from the sale price of an investment. You have to figure out something called the Adjusted Cost Base (ACB), and include that in your calculations.
In short, the ACB includes the purchase price of an asset, plus the costs associated with acquiring it. Here’s a very basic example of how to calculate a capital gain, using the adjusted cost base:
Let’s say you purchased 100 shares of Company Y, at $15.00 per share. If you paid a commission fee of $10 to place the trade, your adjusted cost base would be $1510.00. That is your total cost to make the purchase.
Buy: 100 Shares of Company Y @ $15/share = $1500 + $10 Commission = $1510.00 ACB
Two years later, you decide to sell the same 100 shares of Company X, and the share price has risen to $20.00. You pay another $10 commission to sell the shares. Your selling price will be 100 shares X $20/share – $10 commission = $1990.00
Sell: 100 shares of Company Y @ $20/share = $2000 – $10 Commission = $1990.00
The resulting capital gain for the sale would be $480.00 (Sale price of $1990.00 less Adjusted Cost Base of $1510.00 = $480). From your $480 capital gain, you would claim 50%, or $240, as income, for tax purposes. Assuming a marginal tax rate of 30%, you would pay approximately $72 of tax on an original capital gain of $480.
Keep in mind, the situation I’ve described is very basic. Had you purchased shares at various share prices, not to mention various commission rates, over a period of time, then you would have to determine your average ACB per share, to be able to accurately calculate your capital gain. For more information on how to calculate capital gains, I recommend you visit the CRA website.
Ways to Reduce a Capital Gain
While a capital gain is considered more tax-efficient than other sources of investment income, it’s still a tax, meaning, you want to find ways to minimize how much you’ll pay to the CRA. Thankfully, there are a number of ways you can reduce capital gains, or avoid them altogether.
Time the Sale of a Capital Property
Choosing the right time to sell a capital property can save you thousands of dollars in taxes. While you should always consult a tax professional, a general rule of thumb is to defer paying tax into the future, within the law, of course. For example, if you were planning to sell a rental property at a profit late in the calendar year, it may be to your advantage to hold off until after January 1st. You wouldn’t have to pay tax on the capital gain for an additional 12 months.
Trigger a Capital Gain When Your Income is Low
If your income varies year to year, you may want to claim a capital gain in a year when you expect to have a lower overall income. That’s because any capital gains will be added to your earned income, potentially placing you into a higher tax bracket
Take Advantage of a Capital Loss
You may want to realize a capital gain in a year in which you also incur a capital loss. That’s because capital losses can be used to offset a capital gain, thus reducing your overall tax burden.
Donate to Reduce Your Capital Gain
If you donate regularly to charity and want to avoid paying a capital gain, you can accomplish both by donating stock that that holds the same value of the amount you planned to donate.
Let’s say you had planned to donate $5000 to your preferred charity in 2019, and you also had $5000 of stock, that only cost you $3000 when you purchased it years prior. Donate the stock, by transferring it ‘in kind’ to the charity of your choice. You avoid paying tax on a capital gain of approximately $2000, while receiving credit for your $5000 donation. As I mentioned earlier, always look for ways to defer taxes into the future.
Use the Lifetime Capital Gains Exemption (LCGE)
If you own a Canadian controlled private corporation, or a qualifying farm or fishing business, you may be able to dispose of your property and be exempt from capital gains up to $1MM, by using the Lifetime Capital Gains Exemption (LCGE). Unfortunately, most investors won’t be eligible, as shares of publicly traded companies, or mutual funds, are not included.
Contribute to Tax Sheltered Investment Accounts
For regular investors, it’s easy to avoid paying capital gains tax by investing in government registered investments such as TFSAs, and RRSPs. Because these accounts are tax-sheltered, you won’t need to claim any capital gains. With the RRSP, you will pay income tax when you begin withdrawing at retirement, but you’ll benefit from years of tax-free growth in the meantime.
Sell a Primary Residence
While investment properties, such as a rental home or cottage, are subject to capital gains tax in Canada, the sale of a primary residence remains exempt. So, as the market value of your home rises over the years, there’s no need to worry about having to claim a capital gain when the time comes to sell.
Capital Gains Tax – Glossary of Terms
Making your way through many aspects of capital gains tax can be cumbersome, and for advice related to your individual situation, remember to always consult a tax professional. That said, knowing some of the basic terminologies can go a long way towards understanding how capital gains work. To help, I’ve included the following glossary of related terms:
Adjusted Cost Base (ACB) – the cost to purchase an asset, including any related expenses, such as commissions and other fees. The ACB also includes any additions or capital improvements made to the property.
Capital Cost Allowance (CCA) – Some capital properties, such as a cottage, or a building, deteriorate over time. Because of this, you can deduct its capital cost over a number of years. This is known as a Capital Cost Allowance (CCA).
Capital Gain – A capital gain occurs when you sell a qualifying asset, also known as a capital property, for more than its adjusted cost base (see definition above), as well as any outlays and expenses related to the sale of the property.
Capital Loss – The opposite of a capital gain, a capital loss occurs when a property is sold for less than the amount for which it was acquired.
Capital Property – This includes any property that would trigger a capital gain or a capital loss if sold. In most cases, capital property is used for investment purposes. Examples of capital property include rental properties, stocks, bonds, or mutual funds.
Capital Gains Tax – A tax triggered when you sell a capital property for more than its adjusted cost base, including any outlays and expenses.
Deemed acquisition – A term used to describe when you are considered to have acquired a property, whether or not you in fact purchases it.
Deemed Disposition – This is a term used to describe when a property is considered to have been disposed of, without a sale having taken place. Ceasing to be a resident of Canada, or becoming deceased are examples of situations where this could occur.
Lifetime Capital Gains Exemption (LCGE) – A cumulative capital gains deduction, available to Canadians who sell a qualifying capital property.
Non-arm’s length transaction – A transaction that occurs between, but not limited to, parties who are related to each other.
Outlays and Expenses – Ay expenses you incur to dispose of a capital property.
Proceeds of Disposition – The sale amount of the property, including any related fees and other expenses.