Last updated: Jul. 25, 2024
Explaining Capital Gains: New Inclusion Rates Simplified.
Whether you sold off assets or hedged your bets before Canada’s new capital gains rules kicked in on June 25, understanding these changes is crucial for corporations, trusts, high-income individuals, and even cottage owners.
Let’s start by clearing the air about some common misconceptions:
- Inclusion Rate vs. Tax Rate: The inclusion rate is a portion or percentage of capital gains added to your taxable income and taxed at the marginal rate, not the entire tax rate you pay. You will not be taxed at 50%!
- Impact Breakdown: Individuals benefit from a 50% inclusion rate on the first $250,000 of annual capital gains. Anything over that faces a 66.67% rate. Corporations and trusts see a flat 66.67% rate for all capital gains (earned after June 25, 2024).
- Gifting and Capital Gains: Gifting an asset triggers a capital gains tax based on its Fair Market Value (FMV), not the sale price. Any change in ownership status on an asset may trigger a capital gain – even if no money changes hands.
- Capital Loss Application: Capital losses cannot be applied to personal-use property and depreciable property. The capital cost of depreciable properties can be written off as a Capital Cost Allowance (CCA) over several years, following specific rules and rates.
- Farm/Fishing Exemptions Remain: Bill C-69 increases the Lifetime Capital Gains Exemption (LCGE) for qualified farm and fishing property from a little over $1 million to $1.25 million. It does not change the rules regarding intergenerational farm or fishing property transfers to spouses/common-law partners or children.
Now, let’s delve deeper into capital gains and losses.
- What is a Capital Gain or Loss?
- What are the Capital Gain Inclusion Rate Changes?
- Beyond Inclusion Rates: Tax Planning for Individuals
- Corporations & Trusts: Higher Taxes, Limited Relief
- Capital Gains Tax-Saving Strategies for Individuals
- Planning and Proactive Management: Your Key to Minimizing the Inclusion Rate Impact
What is a Capital Gain or Loss?
Selling a non-primary residence property (cabin, business building, etc.) or disposing of any asset for more than you paid generates a capital gain. Conversely, selling for less results in a loss. Gifting, or any other event where ownership of an asset changes is considered a “deemed disposition,” triggering a potential gain or loss.
To calculate capital gains or losses, use this formula:
| Proceeds from Sale (POD) – Adjusted Cost Base (ACB) = Capital Gain (or Loss) |
Remember, only a portion (the capital gain times the inclusion rate) of your capital gain is taxable income.
What are the Capital Gain Inclusion Rate Changes?
The proposed changes affect how much of your capital gain gets taxed (inclusion rate).
- Individuals: as of June 25, 2024, the inclusion rate is 50% up to $250,000 and 66.67% above that.
- Corporations & Trusts: as of June 25, 2024, the inclusion rate is 66.67%.
Again, these are not tax rates but the percentage of your gain included for tax purposes.
Beyond Inclusion Rates: Tax Planning for Individuals
The new inclusion rates are important, but there are other factors. Here’s how other recent tax changes impact individuals:
- Alternative Minimum Tax (AMT): The AMT ensures “fair taxation” by preventing excessive use of tax benefits.
- Good News: Budget 2024 raises the exemption threshold to $173,000, impacting fewer taxpayers.
- Not-So-Good News: Higher tax rate (20.5%) and 100% capital gains inclusion for those subject to AMT.
- Lifetime Capital Gains Exemption (LCGE) Increase: Bill C-69 proposes raising the LCGE to $1.25 million for qualifying properties.
- General Anti-Avoidance Rule (GAAR): GAAR is a legal tool the CRA uses to prevent people from paying their fair share of taxes. Bill C-59 expands GAAR to impact more transactions and give it more teeth potentially:
- Higher Penalty: 25% of the tax benefit gained through avoidance schemes.
- Lower Threshold: CRA can scrutinize transactions where tax reduction is a significant factor.
- Increased Scrutiny: More CRA resources for investigating potentially abusive transactions and a longer reassessment period (3 years, unless disclosed).
- Timing Capital Gains: Canada’s graduated tax brackets and tiered inclusion rates create opportunities to lower your tax burden by spreading capital gains across tax years.
- Residential Property Flipping Rule (2023): Individuals who buy and resell a property within 12 months generally can’t claim capital gains. Per the new deeming rule, the total net proceeds (sales price less cost) is taxed as business income.
| Example – Capital Gains for an Individual in BC
For this example, we’ll use BC’s highest combined tax brackets. You can compare these numbers against the highest rates in any province, and the effects should be essentially the same.
Increase in tax = $8,915 |
Corporations & Trusts: Higher Taxes, Limited Relief
The changes in capital gains inclusion rate will significantly impact Canadian-controlled private corporations (CCPC) and trusts compared to individuals. Here’s a breakdown of key considerations:
Corporations
- Higher Inclusion Rate: Corporations will be subject to the two-thirds or 66.67% inclusion rate on ALL (100%) capital gains, unlike individuals with the $250,000 threshold. This means a more significant portion of capital gains will be taxed at the corporate income tax rate, which ranges from 46.7% to 54.7% across Canada.
- Limited Dividend Tax Deferral: While a portion of corporate taxes paid on capital gains might be recovered through future dividends, this benefit is limited. The upfront tax burden can be significant without proper tax planning strategies.
- Reduced Small Business Deduction: Increased capital gains taxes can indirectly impact the small business deduction by reducing overall corporate income. The higher inclusion rate and limited tax deferral possibilities through dividends lead to a more significant upfront tax burden. The potential reduction in the small business deduction further complicates the situation.
- Higher Lifetime Capital Gains Exemption (LCGE): As mentioned above, Bill C-69 would increase the LCGE to $1.25 million for qualified small business corporation shares. This measure may provide some relief.
Trusts
Trusts will experience challenges similar to those corporations face regarding the increased capital gains inclusion rate. They will be taxed at the full two-thirds, or 66.67%, rate on all capital gains. Here is the breakdown:
- No Dividend Deferral: Unlike corporations, trusts don’t have the option to defer taxes through dividends, which can result in a more significant upfront tax burden than corporations.
- Potentially Higher Tax Rates: Depending on the type of trust, the income tax rate on capital gains could be even higher than the corporate rate, reaching the highest marginal tax rates.
- Substantial Tax Burden: Trusts will likely face the most significant negative consequences from the inclusion rate of new capital gains. A higher inclusion rate, no option for tax deferral, and potentially higher tax rates create a substantial tax burden.
| Example – Capital Gains for a CCPC in BC Before June 25, 2024
Again, we use BC’s highest combined tax brackets: Capital gain of $350,000
= $88,725 tax
|
| Example – Capital Gains for CCPC in BC After June 25, 2024
Again, we’re using BC’s highest combined tax brackets here. Capital gain of $350,000
Increase in tax = $11,883 Loss of CDA = ($58,345) |
As per our examples, the inclusion rate will result in higher tax (because a greater portion will be included within taxable income) and less money going into a CCPC’s Captial Dividend Account (CDA) – an account used to track and distribute tax-free surpluses to shareholders.
Capital Gains Tax-Saving Strategies for Individuals
As an individual, you may consider realizing your capital gain in one tax year or gradually gifting these family assets to preserve intergenerational wealth by lowering your overall tax burden.
Crystallization – How Locking in a Capital Gain May Preserve Intergenerational Wealth
Imagine you own an investment that has increased in value. “Crystallization” refers to the act of selling that investment to lock in the current value as a capital gain. You deliberately sell the investment, triggering a taxable event – the difference between your purchase and selling prices, otherwise known as a capital gain.
The critical point is that you intend to repurchase the same investment after selling it. Repurchasing the asset allows you to “lock in” the gain and reset the Adjusted Cost Base (ABC) – the new purchase price at a new point in time.
Why Crystallize?
There are several reasons why someone might crystallize a capital gain:
- Lock in Profits: Investors might crystallize gains to secure profits before the asset’s value decreases.
- Tax Planning: Crystallization can help you take advantage of lower rates in a specific tax year or offset capital losses from other investments. For example, if someone has less income in a given year (i.e., they’re on maternity leave or some other Employment Insurance benefit).
- Rebalance Portfolio: Selling an appreciated asset can help rebalance your portfolio’s asset allocation.
Additional Considerations for Crystalizing Capital Gains
While crystallizing a gain offers many benefits, it’s not a one-size-fits-all strategy. Even if your plan involves repurchasing the investment, you must still pay taxes on the capital gain you realized from the sale. For crystallization to work, it must be part of a deliberate tax strategy that reflects your unique investment plan and risk tolerance.
Here are some other factors for consideration:
- Costs: Selling often involves commissions and fees. Make sure the gain is larger than these costs.
- Market Timing: Crystallization locks in your gain at a specific time. If you think the asset’s value will rise further, selling now might limit your profits.
- Investment Horizon: Are you in it for the long haul? Short-term price swings might be less important if you plan to hold the asset for a long time.
- Alternatives: Before selling, explore tax-advantaged investment options that might offer similar returns without triggering a taxable event.
- Liquidity Needs: Selling creates cash, but ensure you don’t need that money readily in the near future. Don’t sacrifice your emergency fund or short-term needs.
- Risk Tolerance: How do you feel about market ups and downs? Crystallization offers peace of mind by locking in gains but also means giving up potential future growth.
- Tax Planning: Understanding current and potential future capital gains tax rates is crucial. Consulting a tax specialist can help you make informed decisions.
- Overall Strategy: Crystallization should be part of a broader investment plan that aligns with your financial goals and risk tolerance.
In the case of a property asset, you deliberately trigger a taxable event based on the difference between your purchase – the Adjusted Cost Base (ABC) – and the selling price – the Proceeds of Disposition (POD). Again, this strategy could apply to any asset, including personal-use property like a cabin or investments like stocks.
Example – Crystallization of Stock for an Individual
By crystallizing a gain, you separate the increase in value (capital gain) from the remaining investment. This allows for potential tax advantages, but remember, you’ll still owe taxes based on the gain you locked in. |
Incremental Gifting of Assets Over Time
As a reminder, the gifting of an asset is considered “deemed disposition” for tax purposes, even though no money is exchanged, especially for gifts between family members (non-arms-length taxpayers).
For tax purposes, the value of the gift is considered its Fair Market Value (FMV), not necessarily what the recipient pays or doesn’t. The CRA defines FMV as “the highest dollar value you can get for your property in an open and unrestricted market, between a willing buyer and a willing seller who are acting independently of each other.”
Under the proposed changes, an individual may earn up to $250,000 in capital gain income and include it at the 50% inclusion rate. This tiered rate for individuals has caused some to consider disposing of assets over time to take advantage of this 50% inclusion rate.
| Example – Incrementally Gifting a Family Cabin In this example, the owner incrementally gifts the family cabin to the desired recipient family member over time. Let’s say the family owns a cabin worth $1.2 million with an adjusted cost base of $200,000. $1.2 million (Fair Market Value) – $200,000 (Adjusted Cost Base) = $1 million (Capital Gain). Even if the owner wishes to gift the cabin to the recipient (i.e., no payment is given), the owner will include the taxable capital gain in their tax return and pay tax on that – despite not receiving a penny. However, the owner could instead gift ownership of the cabin in one-quarter increments, including $250,000 of capital gain income each year over four years. The $250,000 capital gain would be taxable at their marginal rate, the tax would be paid, and ownership would eventually be transferred entirely in the last year, all at the capital gain inclusion rate of 50%.
|
Additional Considerations for Incremental Gifting
Incremental gifting can reduce the overall tax burden by spreading capital gains, but depending on the owner’s unique tax situation, it can also have unintended consequences.
- Clawback of Government Benefits: Increasing your total income could result in a clawback of other tax benefits, like the Old Age Security (OAS) pension. In the cabin example above, the property’s original owner would likely have their OAS clawed back for four years until the property ownership transfer is complete. Alternatively, they could trigger the capital gains within one tax year, which would still result in an OAS clawback, but only for one tax year instead of many.
- Loss of Control/Family Conflict: Many emotions are at play when gifting an asset, especially a family property full of special memories. However, once you gift an asset, you relinquish ownership and control over it. The recipient is now the legal owner; by rights, they can do whatever they want without your permission, including selling, renovating, or even knocking it down. Communication with beneficiaries when gifting an asset during your lifetime is essential to prevent disappointment or surprise.
- Estate Planning Implications: Gifting away assets during your lifetime reduces the value of your estate, potentially lowering estate taxes for your heirs. However, it minimizes the amount of assets available for distribution according to your will.
- Administrative Burden: Tracking multiple gifts and their values can take time and effort. You may need professional help to ensure accurate record-keeping and tax reporting.
- Potential for Abuse Rules: The CRA may scrutinize overly aggressive gifting strategies designed solely to minimize taxes.
That said, there are some opportunities to plan for an effective transfer of assets within a family. Still, it’s crucial to consider the “gift” (i.e., transfers for inadequate consideration) tax implications.
For more about gifting, read “What’s CRA’s Position on Family Gifts?”
Planning and Proactive Management: Your Key to Minimizing the Inclusion Rate Impact
While the inclusion rates for new capital gains is complex, proactive planning and strategic management are your best allies to combat their effects.
Understanding the new inclusion rates, exploring tax-saving strategies like crystallization and incremental gifting, and working with a tax specialist can help you make informed financial decisions.
Remember, knowledge is power. Smart tax planning today lays the groundwork for a stronger financial tomorrow.
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