Canadians must declare capital gains when a property or investment asset is sold for more than its purchase price. Whether you’re selling property, a piece of art or stock investment, if you earned a profit — known as a capital gain — then you are required to pay capital gains tax on that profit.
The big question is — how can you reduce your overall capital gains taxes when it comes time to pay?
What are capital gains (and losses)?
Before we dive into our list of strategies to help you reduce your tax bill, it’s important to understand what exactly is meant by capital gains, and losses.
A capital gain is a profit you earn from the sale of an investment or real property asset.
For example, if you were to purchase $2,000 in stocks, and then sell them a month later for $3,000, you’d realize a profit (known as a gain) of $1,000.
A capital loss is the exact opposite of a capital gain.
If your investment were to take a dive and you were to sell those same stock holdings for $1,500, you’d incur a capital loss of $500.
In other words, your capital gain (or loss) is the difference between the purchase price and the sales price of an asset.
When are capital gain taxes due?
Capital gains and losses can only be realized when you sell. This means any money owed (to the taxman, for a gain or as a credit to you, as a loss) isn’t due until you sell the asset. As long as the asset remains in your investment portfolio or under your ownership, you do not owe tax (or get a credit).
In the case of property, the tax is owed on the capital gain when the property is sold and transfers to a different owner. When the property sold is your primary residence, you may claim an exemption — known as the Primary Residence Exemption. This tax strategy allows homeowners to shelter the profit from their primary residence from taxation by the Canada Revenue Agency (CRA).
Capital gains tax may also be due when there is a change of use in a property — like switching your primary residence to a rental property or vice versa — but the property owner has the option to defer payment of the taxes until the actual disposition, or sale, of the property.
How is capital gains tax calculated?
Assets and investments that trigger capital gains, as opposed to interest or income, are sought after because capital gains tax is considered more favourable than other taxation types.
When you pay capital gains tax you only pay tax on half of the profit. In comparison, you pay tax on all income and all interest earned.
For example, if you buy stock for $15,000 then later sell it for $25,000, you would have a $10,000 capital gain and would owe taxes on that gain. The taxes paid on this type of earning is called a capital gain tax.
No matter the type of tax — income or capital gains — the amount you pay is calculated based on your marginal tax rate. The less income or profit you earn in a calendar year, the lower your marginal tax rate, and the less tax (of any sort) you’ll have to pay.
Still, many people become quite concerned with capital gains tax because, typically, this tax is triggered when larger, more expensive assets are sold — and usually that means larger tax bills.
Thankfully, there are strategies to help reduce the tax you pay on these capital gains and strategies to help you reduce your overall tax bill.
To help here are nine strategies to help reduce your capital gains tax.
Strategy #1: Use tax shelters
The term ‘tax shelter’ is dangerously exciting. It conjures up images of jets flying to tropical islands complete with suitcases of money. But legitimate tax shelters are nothing close to these Hollywood depictions of hidden cash.
Most Canadians can take advantage of tax sheltering through the use of registered accounts.
A registered account is an investment account that is given tax-deferred or tax-sheltered status by the government.
Income earned in this type of account is either not taxed until withdrawal or, in the case of a Tax-Free-Savings-Account (TFSA), the earnings are not subject to taxation.
To ensure that registered accounts are used for their intended purposes — to minimize taxes paid today or in the future, not avoid paying taxes — the government puts rules in place. Investors and institutions offering these accounts must follow these rules are face penalization. Examples of registered accounts in Canada include the Registered Retirement Savings Plan (RRSP), the Registered Education Saving Plan (RESP), and the Registered Retirement Income Fund (RRIF).
To be clear, a non-registered account does not enjoy the same tax-sheltered status as its registered counterpart. That means if you hold stock XYZ in a registered plan, such as an RRSP, you will not be fully taxed on the contributions until you withdraw this money in the future. If, however, you hold that same XYZ stock in a non-registered investment account, you are required to pay taxes annually on income generated by the account.
Tax Tip for 2020:
Canadians have until February 29, 2020 to make contributions to their RRSPs.
The use of these basic tax shelter accounts can significantly reduce your tax bill.
Strategy #2: Understand when and where to invest
Choosing whether to invest in a registered account or a non-registered account depends on a variety of factors, but if your aim is to reduce the tax paid now and in the future, it’s wise to understand what type of assets should be in registered accounts.
While most assets work well in registered accounts, from a tax-saving point of view, it makes sense to hold income-producing investments. Income-producing assets, such as fixed-income securities (ie: bonds) and term deposits (such as GICs and high-interest savings accounts) are good to keep in registered accounts because 100% of the interest income is subject to tax, based on your marginal tax rate. By holding investments that trigger more tax, you end up avoiding a higher tax bill for the current year and your investments end up benefitting from tax-sheltered compound interest growth. Why? Because you will not be taxed on the income until you withdraw. In the case of an RRSP, this typically means the withdrawals will occur when you retire and your marginal tax rate is lower; in the case of RESPs, the money is withdrawn under the beneficiaries name (your child), who is theoretically in a lower tax bracket then you are when the withdrawal is made.
Keep in mind, however, there are pretty stiff penalties for using tax shelters as an ATM or emergency fund. Withdrawals from an RRSP prior to retirement are subject to a 30% withholding fee, on top of the tax owed on the withdrawn funds.
Strategy #3: Take a strategic loss
To reduce capital gains tax it may be wise to take a strategic loss.
In most cases, capital losses can be used to reduce, and possibly eliminate, taxes on capital gains earned in the tax calendar year.
This strategy is particularly useful if you want to dump an investment that no longer fits your investment strategy or criteria. Just be sure you have capital gains, as capital losses cannot be used to reduce income tax owed.
Strategy #4: Sell assets when your income is low
Since your capital gains tax rate is determined by your marginal tax rate, you need to pay attention to your overall earnings during the calendar year. The lower your income, the lower your marginal tax rate, and the smaller the taxman will get from your capital gain.
For instance, if you earned a net salary of $100,000 this year (and for simplicity, you live in Ontario, you’re single and don’t contribute to a registered savings plan or pension) then you’d owe $24,727 in taxes, based on 2017 tax calculators, with a marginal tax rate of 28.13% (provincial and federal combined).
Now, if you also sold an investment condo this year, that earned you a net profit of $40,000, your marginal tax rate would increase to 26.29% and you’d owe $33,409 to the CRA. But take solace, if you’d earned that extra $40K as income, it would’ve bumped you up to the 32.49% tax rate and would’ve paid $42,091 in taxes.
Already, the idea of paying capital gains tax, rather than income tax, is looking a lot better. But what if you could strategically time the sale of your property? For instance, if you know you’re taking a sabbatical, as half your pay, in a year than wait before you sell. That would mean the combined two-year tax bill would be $38,765, versus, the two-year tax bill of $41,517 (if you’d sold the property the year before your sabbatical).
Another way to sell when income is low is to keep your income low. There are times when it makes sense to structure the sale of a property over a four or five-year term. This is when, as the seller, you work out an arrangement with the buyer to receive a portion of sale funds over a four- to five-year term. Just be sure to talk to your Realtor, mortgage broker and accountant about this option to verify you know all the advantages and disadvantages.
Strategy #5: Use Restricted Stock Units (RSUs) and stock grants
Restricted stock units (RSUs) are a way your employer can give you equity in the company. These shares are nearly always worth something, even if the stock price drops dramatically. Quite often RSUs are used as a form of bonus compensation, particularly to executives.
RSUs are different from stock options as they are usually non-transferable. Quite often, RSUs are also subject to forfeiture, meaning the recipient must continue employment with the company and/or meet certain benchmarks in order to benefit from the RSUs (which are cashed out for company stock based on specific time or price parametres).
Restricted stock and RSUs are taxed differently than other stock options. Quite often, employee stock options are taxed in the calendar year or when sold. Earnings on RSUs, on the other hand, are not taxable in the calendar year earned, but when they are converted. While gains on RSUs are typically taxed as income (so subject to full taxation), smart planning allows the holder to strategically spread out the vesting — conversion of RSUs to stock options — timetable. This would allow the RSU recipient to smooth out the tax hit over a period of time, rather than being subject to a big tax bill during one calendar year.
Strategy #6: Start a small business
If you earn a significant income from your investments or property, you might want to consider starting a small business to help you reduce or eliminate any taxes on your capital gains.
Owning a registered business provides many tax breaks, which include business expenses, travel expenses, office supplies, utilities, etc.
Keep in mind, however, the business needs to be legitimate; you need to keep records and receipts and you must have a reasonable expectation of earning a profit.
Strategy #7: Hold life insurance
In the event of death, the sale of a home, cottage, or major asset could incur significant taxes on capital gains.
In the event that an estate does not have sufficient liquid assets to cover the taxes levied upon the sale of a property or asset, holding life insurance can help cover these costs.
Proceeds from life insurance payouts are not taxed in Canada, plus some insurance policies (such as Whole Life or Universal) can be used as an investment strategy.
Strategy #8: Transfer your money to a trust
A trust is a legal contract where one person (who owns the asset) gives the authority to another person (or legal entity) to manage the assets on behalf of another person (beneficiaries).
Trusts are used to remove the ownership of assets from one person — typically someone in a higher tax bracket — so that taxes owed on an annual basis can be reduced and/or shared among different beneficiaries.
A common type of trust that is used to help reduce taxes is a family trust. The trust is set up so that different family members have shares in the trust. Each ‘shareholder’ of the trust is entitled to proceeds (either from investments or through the sale of assets). The trust helps to reduce annual taxes because it shares the tax among different trust owners, rather than on one beneficial owner.
Since trusts use a ‘share’ structure, they can pay out dividends, which is another way trust owners can reduce taxes. A trust can disburse funds among many beneficiaries, who are then able to take advantage of the dividend tax credit — non-refundable federal and provincial tax credits that taxpayers can use to reduce double taxation on dividend producing investments.
To really take advantage of trusts, it’s best to talk to a professional and keep in mind there are one-time and annual costs associated with using trusts.
Strategy #9: Invest in your principal residence
Our final tax strategy to help you reduce your capital gains tax bill is to invest money into your principal residence.
While the cost of renovations and improvements to your home are not tax-deductible, they can help increase the market value of your home. Since the profit earned on the sale of your principal residence is sheltered from taxation through the principal residence exemption, it can make sense to make improvements in your primary property.