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Table of Contents
What Are Capital Gains?
There are two main goals to investing.
The first is to acquire an asset for income-generation, such as a dividend on a stock or interest from a bond.
The second is to acquire an asset with the expectation that the value of the asset will increase over time and can be sold at a profit.
When an investor sells an investment asset at a price higher than the initial price of acquisition and makes a profit, this is considered a capital gain.
When an investment is sold at a price lower than the initial price of acquisition and a loss is made, this is considered a capital loss.
Disclaimer:
Equity investments are subject to market risks and may not be suitable for all investors. If you have any doubts as to the merits of an investment, you should seek advice from an independent financial advisor. So please invest at your own risk.
What Is a Capital Gains Tax?
Capital gains tax is the tax levied on the profit made from the sale of an investment asset such as bonds, stocks, mutual funds, and investment property.
Capital gains can be classified into realized capital gains and unrealized capital gains.
An unrealized capital gain is when the investment increases in value but is yet to be sold.
A realized capital gain is when the investment increases in value and has been sold.
Capital gains tax is only levied on capital gains realized.
In the case of capital loss, the Canada Revenue Agency allows you to use those losses to offset capital gains when you file your income tax return.
What Is the Capital Gains Tax Rate?
You only pay capital gains tax on 50% of your capital gains, and the tax is calculated at the marginal tax rate of your income level.
In the case of a day trader, the Canada Revenue Agency will consider the other half of your capital gains as taxable income. In this case, you will pay more capital gains taxes since 100% of your profit is now considered business income.
Once an investor has calculated the realized capital gain, they are expected to report the taxable capital gain as income to the CRA so that they can pay tax on those gains.
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How to Calculate Capital Gain
Before you send in your tax returns, it’s important to know how to calculate your capital tax gain or loss.
When calculating capital gains, three amounts need to be calculated first. They are;
- The adjusted cost base (ACB): the price the investment was purchased at, including legal fees or commissions.
- The proceeds of disposition: Amount received after the sale.
- Expenses incurred by the sale of the investment.
Once these are in order, the calculation for Capital gains becomes;
- Capital gain = Proceeds of disposition – (ACB + Expenses incurred by the sale of the investment).
Here’s an example of this in action.
Let’s say you made an investment a year ago and, at the time, decided to buy stock in a company.
You purchased 1000 shares at $10 a share and incurred a commission of $100.
The adjusted cost base, in this case, would total $10,100.
Fast forward to the present day, and you decide to sell the shares. The company’s share price is now at $20.
Your total proceeds of disposition would now be $20,000, and you would incur a commission of $100.
- Your capital gain will now be = $20,000 – ($10,100 + “$100) = $9,800
- Your taxable capital gain tax (that you report) would then be half of that = $4,900
Any income generated through day trading or active trading is regarded as business income by the CRA.
Once you calculate the capital gain, you are expected to report it as income to the CRA.
This is done through form 5000-S3 Schedule 3 as income for the tax year in which the asset was sold.
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How to Avoid Paying Capital Gains Tax?
Several avenues can be used to avoid capital gains tax. They include;
Tax Loss Harvesting
Tax loss harvesting involves using capital losses to offset your payable capital gains.
This involves selling off poor-performing assets, triggering a capital loss, and then using the capital loss to reduce the amount of capital gains tax owed to the tax authorities.
Capital losses can only be used to offset capital gains exclusively. No other income can be offset using capital losses.
Capital losses can also be used to offset capital gains for previous tax years (maximum of 3) and can also be indefinitely carried forward into the future.
Although Tax loss harvesting is perfectly legal, it is essential to avoid gaming the system
The CRA does not take kindly to investors who sell off assets to trigger tax losses just to buy them days later, creating what is called a Superficial loss.
If deemed a superficial loss by authorities, you will not be allowed to use the capital loss to offset your capital gains, and not only that, you end up setting yourself up for future audits and scrutiny by tax authorities.
Using Tax-Advantaged Accounts.
Another way to reduce or avoid your taxable capital gains is using tax-sheltered accounts such as an RRSP or a Tax-free savings account.
In these accounts, gains, dividends, or interests accrued by these accounts can be withdrawn tax-free (in the case of TFSA) or on a tax-deferred basis(in the case of an RRSP).
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Donating Your Investments.
Donating your investments is another good way to eliminate or reduce your taxable capital gains tax, e.g., shares.
Donations made out to registered charities are exempt from capital gains tax and don’t require inclusion in your tax return as an income.
This is a good way to rebalance your investment portfolio without triggering capital gains that would warrant taxation.
Claiming a Federal Dividend Tax Credit
Dividend income gets taxed separately from capital gains tax.
Eligible dividends are taxed at 38% gross, while non-eligible dividends are taxed at 15%.
Financial institutions and brokers usually issue a T5 Statement of Investment Income that details these amounts.
By claiming the non-refundable federal dividend tax credit, you can offset the taxes you have to pay on the gross amount of your dividends.
Read Relevant: Meaning of line 10100 on income tax return
Conclusion
Though initially confusing, the process of understanding and calculating capital gains tax isn’t as daunting as it may seem once you have the right information.
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