Assets which have been held to produce income or appreciate will at some time be sold or otherwise disposed of, often generating a capital gain; sometimes a capital loss. Capital gains are subject to preferred tax treatment. We will take a closer look at how to maximize these opportunities; however, a clarification is necessary before we begin.
Capital gains and losses earned inside a registered account will lose their identity. For example when you earn a capital gain in your RRSP, the gain is added to the value of the plan, but later, upon withdrawal of the funds, the full amount of principal and earnings are taxable.
Therefore, it may be good to hold assets that produce capital treatment outside your registered accounts if you want to benefit from the preferred tax treatment. This is generally true except for investments in a Tax-Free Savings Account. In that case, all resulting income, including capital gains is tax exempt.
The discussion below takes a general approach for the purposes of understanding how the acquisition and disposition of assets can affect net worth and cash flow from a tax point of view. The topic is detailed and can be complicated, and so the hope is that the information will arm you with enough information to ask better questions of your financial advisors resulting in more knowledgeable decision making.
To understand the tax consequences that could occur when you sell an income-producing asset, it is important to understand what a capital gain is. Simply put, a capital gain arises when an asset is disposed of for more than its adjusted cost base. In an equation, the calculation looks like this:
Capital Gain = Proceeds of Disposition - Adjusted Cost Base
This simple definition requires some explanation of the terms; for example, many people can understand that a capital gain may happen upon a sale of an asset. That is included in the definition of "proceeds of disposition." In that case, money changes hands between a seller and a buyer.
However, a tax consequence also may occur when there is a "deemed disposition." That is, a taxable event is considered to have happened in these circumstances:
In these situations, the proceeds of disposition will generally be the Fair Market Value (FMV) of the asset at the time of disposition. This is important, as an appraisal is necessary to justify that valuation for tax purposes.
When it comes to real estate held by a taxpayer for personal use and enjoyment, the gains on the disposition of a property designated as the principal residence will not be taxable.
If the taxpayer converts that personal use property to an income producing property, a change in use will generally be deemed to have occurred. In that case of such a "deemed disposition", a taxable consequence based on the FMV of the property at the time of the change must be reported, although some optional elections may defer the actual payment of taxes.
The Adjusted Cost Base (ACB) of an asset is its tax cost. It is made up of:
This latter point is important. The ACB of the property can be increased by costs incurred to improve the useful life of the property. This is different from repairs, which restore the asset to its original condition. An example of a capital addition to the cost base of a revenue property, for example, would be the cost of a new roof, a new deck, landscaping or a boat house. An example of a repair would be the replacement of shingles, or maintenance like the painting of a fence.
There is one more thing you need to know about calculating Proceeds of Disposition and Adjusted Cost Base of an asset for tax purposes: the length of time the asset has been held will affect its cost base. Special rules exist for the calculation of ACB for taxpayers who owned capital property on a "Valuation Day".
Did you know there was no capital gains tax in Canada before 1972? The cost base to the taxpayer who has owned an asset prior to this will calculate its cost based on the "median" value of:
Other valuation days are possible when the asset being disposed of is a principal residence.
Once we know what the right figures are for Proceeds of Disposition and the Adjusted Cost Base, we can calculate the capital gain on the sale of our asset. The ACB is simply subtracted from the net proceeds of disposition. We can also deduct any cost of making the sale, like commissions or appraisals, for example.
Next, we need to determine how much of this is taxable. Today, for most assets, 50% of the gain is included in income as the "taxable capital gain". However, that income inclusion rate of 50% was not always so: as you know, capital gains were not taxable at all prior to 1972; and since then, various governments have tinkered with the inclusion rates so that the history of the capital gains inclusion rates looks like this:
Example: Jason sold some of his publicly traded shares at the start of the year and realized a capital gain of $150,000. What is the taxable capital gain?
Answer: The taxable capital gain is $75,000 (= 1/2 of $150,000).
Assume the same facts as above, but this time, assume that Jason donated shares to a registered charity. What is the taxable capital gain?
Answer: The taxable capital gain is $0. That's because Jason can roll over or transfer the shares on a tax-free basis to his favourite charity and avoid including the taxable gain realized on the transfer in income. He will also receive a charitable donation receipt for FMV of the transferred shares, which will reduce his taxes payable.
A capital loss occurs when an income-producing asset is sold, or deemed to have been disposed of, for less than the total of its adjusted cost base (ACB) and outlays and expenses on disposition.
This is important: any capital losses incurred will offset capital gains earned in the year, but generally not other income.
There is more good news: if losses exceed gains in the current year they may be carried back to any of the previous three years or forward to any subsequent year, to offset capital gains reported in those year. That's a great way to reach back and recover taxes previously reported as a result of a bull market!
And if you don't have any capital gains this year or the previous three and never have another capital gain as long as you live (don't worry things will likely turn around!), here's what you need to know: don't make the mistake of not reporting your net capital losses. Those losses will offset all other income in the year of death and in the immediately preceding tax year. They are therefore valuable and no matter how unpleasant this may seem to you, 'fess up at tax time, okay?
At year end it is not unusual for investors and their advisors to review portfolios for the purpose of offsetting capital gains of the prior three years with capital losses of the current year. This is an important way to average down the taxes paid on capital appreciation and increase cash flow used to reinvest or pay down debt. Speak to your tax and financial advisors to prepare the right formula for loss realization: one that provides a refund in the prior year in which the highest tax liabilities occurred.
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