Capital Gains Tax: What is it and How to Avoid It

Unfortunately, when you invest in property that generates income as part of your financial planning, paying taxes to the Canada Revenue Agency (CRA) is part of the expense. This is especially true for capital property in Canada

The best way to reduce your overall tax expense is by sitting down with the best tax accountants in Toronto and taking advantage of professional tax planning that considers short- medium- and long-term financial goals and helps you optimize your income accordingly.

Before getting too far ahead on how to minimize or “avoid” your Canadian (& Ontario) capital gains tax expense, let’s take a closer look capital property for a more precise definition of what it is.

What is Capital Property in Canadian Tax Reporting?

The CRA considers capital property to be purchases and investments that, as a general rule of thumb, are intended to increase personal or corporate revenues, and that can depreciate or appreciate in value.

Examples of capital property given by the CRA include:

• Property you buy, such as land, buildings, equipment, and tools, that is used to generate income through a business or rental property.
• Investment securities like bonds, stocks and units of a mutual fund trust.
• Cottages.

It’s crucial to know that:

1. Capital property does not apply to your primary residence.
2. Income generated from the different types of capital property is classified and taxed differently. See the section: “Paying Income and Capital Gains Tax in Canada From Revenue Generated by Capital Property” for the specifics.

Also, keep in mind that even though businesses buy assets (i.e., inventory) that they sell or trade for a profit (or a loss) as a part of their operations, they are not classified as capital property.

What is Capital Gains Tax in Canada?

When you sell capital property in Canada, regardless of whether you profited from the sale or not, you must complete a Schedule 3, Capital Gains (or Losses) (for all). However, profits on the sale of capital property are taxed as “capital gains.” Selling (or disposing of) capital property for less than you purchased it for and/or invested in it results in “capital losses.”

Bear in mind that the CRA considers capital property to have been “sold” in situations that wouldn’t normally be described as a sale in everyday language. Giving capital property as a gift, converting securities and the destruction of your capital property are some of the ways it is “sold” when reporting capital gains and losses on your Canadian and Ontario (provincial) tax filings.

How much you pay in Canadian capital gains tax is based on a percentage of the total amount of your capital gains after subtracting your costs.

Who Pays Capital Gains Tax in Canada (& Ontario)?

To determine if you need to pay capital gains tax, and how much to pay, you must know as a starting point:

1. If you profited from the sale and
2. The exact amount of your earnings for tax purposes.

In other words, you must accurately calculate the cost of Canadian capital property in accordance with federal and provincial guidelines.

Since your capital property, especially if it’s real estate, may have required a larger investment than its purchase price, your cost can be significantly higher. Simply subtracting the purchase price from the sale price will not tell you how much you actually profited (operating expenses are not included, however, as you’ll soon see.)

You are allowed to subtract the “adjusted cost base” (ACB) from the revenue generated by your capital property. Continuing with the real estate example, your ACB can include some of the expenses incurred along the way, including:

• The costs to sell the property, known as outlays and expenses. These can include lawyer’s fees, land transfer tax, real estate agent commissions, and other expenses incurred in the sale of your capital property.
• Costs to improve your capital property. So finishing the basement of a rental property, for example, can be considered a capital cost since doing so would allow you to rent out the basement to another tenant and increase its property value.
• Capital costs, however, do not include current costs – your expenses to maintain the property, such as necessary repairs, hydro bills, property management fees, etc. (e.g., your operating expenses on an income-earning rental property.)

Knowing what classifies as capital property and which costs you can include in your ACB with certainty are just two reasons why you should always seek tax tips from professionals before filing your return(s). This is especially true when you have “gray-area” properties and expenses.

Capital Losses

If you lost money on your investment in capital property and incurred capital losses in its disposition, those losses can offset your capital gains tax expense in Canada:

• For the tax year(s) that you incur capital losses.
• Going as far back as three years.
• Moving forward to future Canadian (and provincial) income tax returns.

Strategizing when to take advantage of these and other tax saving opportunities for Canadians is just another of the many benefits of consulting a tax professional for advice before filing your return(s).

Paying Income and Capital Gains Tax in Canada From Revenue Generated by Capital Property

Canadian capital property is taxed at different rates depending on how it generates revenue. When filling out your federal and Ontario (provincial) tax returns, for example:

• Only 50% of your capital gains in Canada are taxable. They must be reported as part of your annual taxable income and are subject to your marginal tax rate. For example, if you profited $50,000 from the sale of an investment property, you must add $25,000 to your income for that tax year.
• Money earned on assets such as bonds and GICs, i.e., interest, must be included in your reported income for the tax year and is taxed at your marginal tax rate.
• On the other hand, dividend income, which is the money earned from eligible stocks, is taxed at a lower rate than interest income. Canadian stocks that pay dividends may qualify for the dividend tax credit. Speak with a certified CPA or consult the CRA for eligibility and calculation criteria.

Tax rates, including capital gains tax in Canada & Ontario, are subject to change. Always check with both the CRA and the Ontario Ministry of Finance page for the latest tax information. Links to similar web pages for every province can be found here.

How to Avoid Paying Capital Gains Tax in Canada (& Ontario)

The following ways of reducing your Canadian capital gains tax amounts are to be distinguished from a capital gains exemption such as the Lifetime Capital Gains Exemption (“LCGE”), where business owners can use an exemption and avoid paying capital gains tax in Canada when selling capital property that qualifies for the exemption, such as certain shares in a small business and property of farming and fishing businesses.

Here are some of the ways to reduce your capital gains taxes:

• Strategically plan how to dispose of your capital gains and use your capital losses. Decisions like waiting for a year when you will have a lower income to sell capital property, using capital losses in a tax year you have higher capital gains instead of the year they were incurred, and deferring capital gains if you do not expect to receive the funds from the sale immediately are some of the ways to avoid paying more capital gains tax in Canada.
• Invest in tax-sheltered and tax-free accounts. You can avoid paying capital gains tax in Canada and Ontario through a tax-free savings account (TFSA). Neither the income generated in a TFSA nor withdrawals from it are taxed, including capital gains. They are, however, capped, and contributions over the cap are taxed monthly. You can also reduce your taxable Canadian capital gains if they are in an RRSP. They are not taxed until you withdraw them, which allows you to withdraw smaller amounts and avoid some capital gains tax. It’s vital to note, however, that capital losses in registered accounts can’t be used to offset gains in other accounts.
• Make charitable donations. If you’ve realized capital gains, by definition, you’ve paid less for the property than it is currently worth. If you donate that property to a cause you’re passionate about, not only are you supporting that charity, but you are also avoiding capital gains tax and receiving a tax credit for a higher dollar amount than you originally paid/invested in the property.

The bottom line is, Canadian tax laws are complicated and knowing how to file your return(s) accurately while also minimizing your obligations, like the Canadian capital gains tax, requires the help of an expert. Reach out to us today to begin your journey to paying lower taxes.