Taxes are an inevitable financial responsibility. You need to pay taxes on your wages as well as your business income.
But that’s not all. If you invest, whether it’s in stocks, funds, precious metals, commodities, or real estate, you are expected to pay taxes on the gains or profits you get from these investments as well.
That’s if your assets are not inside a tax-sheltered account. So, to ensure that you remain in the Canadian Revenue Agency’s (CRA) good books, you need to understand the capital gains tax in Canada.
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What Is Capital Gains Tax in Canada?
Capital gains tax in Canada is the tax you pay when you realize any capital gains.
Capital Gains and Capital Losses – Simple Example
Let’s take a step back and understand what an investment is. An investment is when you buy an asset at a certain price and wait for it to grow in value so you can sell it at a profit.
Let’s say you bought an item for $10 and, sometime later, sold it for $12. In this case, you earned a profit of $2.
But suppose luck and the market didn’t favour you. The object’s price goes down, and you are forced to sell it at a lower price, say $7. In this case, you sustained a $3 loss.
From these examples, the profits you make off of an investment can be considered capital gains. On the other hand, the loss you sustain is dubbed capital loss.
Here, the word “capital” refers to the amount you invested in the investment asset.
Realized and Unrealized Capital Gains/Losses
If you have an investment asset in your possession that’s increasing in value, but you haven’t sold it yet to cash in your profits, your gains would remain unrealized. This is because you haven’t reclaimed your capital nor captured the profit on top of your investment asset. Your money is still tied to the investment asset.
But once you sell the investment asset and reclaim the capital and the profit, you have realized your gains.
Unrealized gains or losses are also called paper gains or losses because they only happen on paper, i.e., theoretically. They don’t impact your finances until they are realized. Therefore, the CRA taxes capital gains only after they are realized.
Capital Gains Tax and Tax Rate in Canada
Once you have realized your capital gains off of an investment asset, you need to pay taxes on them as well. The taxes in Canada are calculated based on two critical variables:
Inclusion Rate: The inclusion rate refers to how much of your capital gains will be taxed by the CRA. For now, the inclusion rate is 50%. This means that only half of your capital gains will be taxed by the CRA. So, if you have realized capital gains of $200, you will get to keep half of it ($100) tax-free and pay taxes on the other half.
Your Regular Tax Rate: Once you have determined the number of capital gains that you need to pay taxes on, you simply need to add it to your taxable income for the year, and it will be taxed at your regular tax rate.
How Capital Gains/Losses and Capital Gains Tax in Canada Is Calculated
The inclusion rate and your regular tax rate are usually just the rates that apply to your tax. Calculating the amount of capital gain is a bit different. To understand that, you need to understand a few standard terms associated with these calculations:
Adjusted Cost Base (ACB): The amount you pay for the investment asset along with any of the associated costs, fees, expenses, etc. It’s the entire cost of acquiring an asset. For simple assets, the book value (i.e., the core cost of the asset) and ACB are usually the same. For others, like real estate, there is a lot of difference between the two.
Proceeds of the Disposition: It’s simply the amount you receive when you dispose of the asset, i.e., sell it to a buyer.
Capital Gains/Losses: These are calculated based on the above concepts.
If Proceeds are greater than the ACB, you incur a capital gain, which is calculated as:
Capital Gains = Proceeds of the Disposition – ACB
However, if your ACB is greater than the Proceeds, you will then suffer a loss:
Capital Losses = ACB – Proceeds of the Disposition
Fair Market Value: The market value of an asset at the time of disposition. This is useful when you convert one asset to another without actually selling it.
Examples of Capital Gains/Losses Calculation
Let’s take a look at the following examples:
You bought an investment property for $500,000. You paid $25,000 in commissions, legal fees, and a few improvements you made on the property, which brings your ACB up to $525,000. You rented out the property for one year and sold it the following year.
Your earnings from the property and the cost of maintaining the property will not change the ACB. If you sold the property for $560,000, you incurred a $35,000 profit (Capital Gains = $560,000 (Proceeds) – $525,000 (ACB)). Only half of it is taxable, so you will add $17,500 to your taxable income for the year.
You buy 50 shares in a company at $10 apiece. Thanks to commission-free trading, you don’t have to pay any additional fees on these shares. So, your ACB comes out to $500, which is the book value of the shares.
After some time, the company starts losing its value, and you sell half your stake (25 shares) at $8 per share. But near the end of the year, the share price spikes, and you sell the remaining 25 shares at $13 apiece.
If all those instances occurred within the year, you would earn a cumulative gain from your investments, incurring capital gains of $25. That’s because, in total, you bought the stocks for $500 and sold them all for $525.
If it happens in two different years, you incurred loss in the $8/share transaction and capital gains in the $13/share transaction. But even if you use the former to offset the latter, the net result might not be the same because your income and, consequently, your tax rate for the two years might be different.
The calculation gets a bit trickier when you buy shares in two different instances and at two different prices. Which will you use to calculate your ACB? In that case, you will simply average out the two (or more) cost prices to come up with an accurate ACB.
Tax Treatment of Capital Loss
You pay taxes on capital gains, but what about capital losses? If the CRA starts taking a cut from investment transactions even when you have sustained a loss, it would be like rubbing salt on your financial wounds.
So, the department doesn’t deduct taxes from capital losses. In fact, the CRA allows you to use your capital losses to offset your tax obligation that stems from capital gains. You can do it, too, in three ways:
- Carry the loss back up to three years;
- Carry the loss forward indefinitely; and
- Use a capital loss to offset capital gains for the year.
- Carry Capital Loss Backward
You can carry capital losses back up to three years. This means you can use the capital losses you’ve sustained in the current year to balance the tax you have already paid for capital gains in the last three years. This allows you to:
- Get a refund; and
- Reduce the amount of back taxes you owe.
There is a minor complication of inclusion rate calculation, but it doesn’t apply to 2020 tax calculations because the inclusion rate has been 50% for the last three years. But if it changes in the future, you’d have to average out the inclusion rate for the year you are calculating your taxes for (also the year you sustained the loss in), and the year(s) you are carrying the loss backward for.
Let’s say you suffered a capital loss of $1,000 for the year 2020. You paid taxes on capital gains of $200 and $400 in the last two years. You can offset and get a refund for $600 and carry the remaining $400 of your current capital loss forward.
- Carry Capital Loss Forward
The current taxation rules allow you to carry your capital loss forward indefinitely. It means that even if you sustained a capital loss twenty years ago and haven’t used it yet to offset your capital gains tax, you can use it now. You will have to adjust for the inclusion rate based on the table below:
Rest assured, your capital loss will always allow you to offset the tax obligation you get from capital gains.
How Capital Gains Tax in Canada Works
Now that you know what capital gains tax is in Canada, let’s see how it works.
The first thing you have to understand is that selling an asset is just one way to realize capital gains. There are other ways you can dispose of your asset as well.
Bartering one investment asset for another, using it to cancel or repay your debts, and changing the ownership of acquisition are just some of the ways you can dispose of your investment assets or properties that trigger a capital gain tax or loss.
It’s important to note that a capital gain isn’t merely triggered by dedicated investment assets nor personal-use properties like cars, boats, bikes, and your home. But the rules around them are different. For example, vehicles usually depreciate, but you can’t use the “loss” from selling them to offset your capital gains.
Similarly, if your home is considered your primary residence, you might not need to pay any capital taxes, even if it substantially increased in value and you realized significant capital gains from selling the property.
Assets that almost always trigger a capital gains tax include:
- Shares, mutual funds, ETFs, and bonds
- Real estate
- Crypto assets
- Jewelry/precious metal
But it’s important to note that selling or disposing of these assets isn’t always considered a capital gain or loss. In some cases, it’s considered business income and taxed as such.
Capital Gains vs. Business Income
Not all transactions and dispositions of properties trigger a capital gains tax because some of them are considered business income.
Take trading as an example. Unlike buy and hold investors, stock traders and crypto traders buy and sell stocks and ETFs several times a day, week, or even a year. In their case, the capital gains tax (or capital loss benefit) doesn’t kick in for every transaction. Instead, it’s considered their business, and the profits and losses are calculated as part of their business income.
The effect is also seen in real estate investors versus flippers. For real estate investors—even those who own rental properties—buying and selling a home after a decent time usually result in capital gains. However, for flippers who buy, improve, and sell a property as soon as possible, the same transaction is considered a business, and the tax difference is significant.
Let’s say you bought a property two years ago and rented it out. This year, you sell it and realize a capital gain of $100,000. You are only going to be taxed for half of it. Even if you are in the highest tax bracket, with a 50% tax rate, you will end up paying $25,000 in taxes on that $100,000 profit.
On the other hand, if a flipper bought your property, improved it, and sold it for a $100,000 profit, they might be taxed differently.
In their case, they would need to pay taxes on the whole $100,000 sum. Based on the tax rate, this difference in treatment can mean a significant difference between the two tax amounts.
The CRA decides whether it’s business income or capital gains on investments based on your intent and many other factors, like the duration between the asset’s acquisition and disposition.
How Do I Avoid Capital Gains Tax in Canada?
There are a few ways to avoid or minimize your capital gains tax in Canada:
- Keep eligible assets in tax-sheltered registered accounts, such as Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP).
- Use capital losses from previous years or this year to offset your capital gains fully or partially.
- Employ tax-loss harvesting, i.e., sell poor-performing investment assets to generate a loss that offsets your tax gains.
- Donate your investment assets in kind, i.e., without selling them, to qualified charities.
- Defer the capital gains from the shares of eligible small business corporations.
What Is Superficial Loss in Canada?
If you sell your investment assets at a low price and repurchase them later to generate a capital loss that you can use to offset your capital gains, the CRA might deem it a superficial loss. It won’t be eligible for offsetting capital gains since it overlaps with tax-loss harvesting. However, there are several differentiating factors, including the time difference between two transactions and the assets you sell to realize a capital loss.
Is There Capital Gains Tax on Selling a House in Canada?
Not if it’s deemed your primary residence. However, if it’s considered an investment property and sold for a profit, then yes. In some cases, selling a house for a profit might be regarded as business income and taxed differently.
How Long Do You Have to Live in a House to Avoid Capital Gains Tax in Canada?
The CRA doesn’t explicitly specify a timeline about how long you have to live in a house before it’s considered your primary residence and exempted from capital gains tax. However, if you or your family members have inhabited a property for some time of the year, and it’s not your business to buy properties, live there for a time, and sell them for a profit, you might be able to avoid capital gains tax.
Capital gains tax is one of the reasons why you’re always encouraged to fill your tax-sheltered accounts to the brim before looking into investment assets that can’t be placed in registered accounts. But there is no need to sacrifice profits or gains for fear of taxes.
Understanding capital gains tax in Canada is significant for real estate investors to figure out ways of maximizing their returns from their investment properties.
It’s important to note that the advice and examples stated above are written from the perspective of a broader audience, so if you have any specific tax-related questions, make sure to contact a CPA.