If you've recently earned profit from selling an investment, you may be required to pay capital gains tax. In Canada, capital gains or losses are realized only when assets (such as stocks, bonds, precious metals, real estate, or other property) are sold and are subject to capital gains tax.
In this article, we will focus solely on gains realized through the sale of securities (most notably stocks). A good understanding of this form of taxation may help you formulate personalized tax saving strategies.
While this article offers general guidance, it is not tax or investment advice. It is always in your best interest to work with a tax or investment professional who can offer personalized support.
Capital Gain vs. Capital Loss
A capital gain occurs when you sell an asset for more than its adjusted cost base (ACB). The ACB is simply the purchase price of the investment, plus any acquisition costs, such as commissions or legal fees.
For example, let’s say you purchased an asset for $100 and later sold it for $200. The difference between the purchase price and the sale price (i.e., $100) is the capital gain.
On the other hand, a capital loss occurs when you sell an asset for less than its ACB.
When filing your personal income tax return, the Federal and provincial taxation authorities, such as the Canada Revenue Agency (CRA), allow you to offset capital gains with capital losses, thus sheltering the capital gain from taxation. Take note that capital losses can be used to offset a capital gain in any of the 3 preceding years or in any future year (i.e., they do not expire).
How Capital Gains Tax is calculated
In Canada, the taxable capital gain must be reported as income on your tax return for the year the asset was sold. The income is considered 50% of the capital gain.
For example, if you sold an asset for $2,000 that has an ACB of $1,000, the taxable income is $500. ($1,000 gain x 50%). The $500 will need to be added as taxable income and you'll be taxed at your marginal tax rate based on your tax bracket.
Capital Gains vs. Interest and Dividend Income
It's important to understand how different types of investment income is calculated for income tax.
- Capital gains: In Canada, only 50% of the total capital gains is taxable. It is included in your annual taxable income and taxed at your marginal tax rate. Capital gains only apply when you sell an asset at a profit.
- Interest Income: The money earned in the form of interest on assets, such as bonds and GICs, is taxed at the same marginal tax rate as ordinary income. For example, $100 interest earned on a 1-year GIC must be included in your annual total income.
- Dividend Income: The money earned in the form of stock dividends is taxed at a lower tax rate than interest income. Canadian dividend-paying stocks may be eligible for the dividend tax credit. For eligibility and calculation, please visit CRA site.
Day trading and Capital Gains Tax
If your income is primarily derived from capital gains, it may be treated as business income by the CRA. This would lead to it being fully taxed at your marginal tax rate instead of the 50% capital gain inclusion. The CRA classifies any income generated through day trading or active trading as business income.
Minimizing Capital Gains Tax
Here are a few ways to reduce your capital gains tax burden in Canada
Use tax-free or tax-sheltered accounts: A tax-free savings account (TFSA) can help you avoid capital gains tax. The income you earn in a TFSA, regardless of the type of income, is not taxable, even when the gain is realized. Funds withdrawn from a TFSA are also not taxable. The only exception is dividend income from U.S. corporations, which will generally be subject to U.S. withholding tax. Please note, TFSAs have a yearly contribution limit and exceeding your limit results in monthly taxation on the excess amount. Read: How to make the most of your TFSA contribution limit
A registered retirement savings plan (RRSP) can also help reduce your tax burden. Capital gains earned on income in an RRSP are not taxable when the gain is realized but rather when the funds are withdrawn. These withdrawals are taxed at your marginal tax rate as ordinary income.
Tax loss harvesting: In Canada, you can offset capital gains with capital losses. This reduces your overall tax burden and is known as tax loss harvesting. Lower-performing funds in a portfolio generate a capital loss that may be used to offset all or part of any realized capital gains. These capital losses can be used to offset any gains realized in the last three years or in any future year as they do not expire. Please note that capital gains inside registered accounts, such as an RRSP or TFSA, are tax exempt. The CRA does not allow the use of capital losses within registered accounts to offset gains in other accounts.
Track expenses: It's a good idea to keep track of any qualifying expenses incurred in securing or maintaining investments (For example, management, legal or trading fees) as these expenses may increase the adjusted cost basis (ACB) of your investments. Capital gains tax is calculated when an asset is sold for more than its ACB.
Capital gain income is a sign that your investments are growing. Careful planning, however, is essential when it comes to getting the best tax benefit.
The information contained herein has been provided by TD Direct Investing and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.
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