Pay less capital gains tax

It’s possible to defer, reduce and sometimes even avoid capital gains taxes

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by

From the November 2014 issue of the magazine.

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(Illustration by Lauren Hom)

(Illustration by Lauren Hom)

Of all the questions MoneySense receives (and we get a lot), the most popular is “How can I avoid capital gains taxes?” No wonder: capital gains taxes can take a big bite out of your wealth. It seems unfair that you have to fork over money to the government just for investing well, and most of us would rather run across hot coals than pay them.

Unfortunately, the sad truth is that—with a few important exceptions—you have to pay capital gains taxes whenever you sell investments, property or other assets for more than you bought them for. So if you buy a stock for $100 and sell it for $150 a few years later, your capital gain is $50 (less commissions or other expenses), and you have to pay tax on that amount.

The good news is that unlike regular income, only 50% of capital gains are taxable. Plus, you don’t have to pay until you sell the asset. Bottom line is—despite their bad rap—capital gains can actually be the most tax-friendly of all investment returns, and there are plenty of ways to defer, reduce or even avoid them altogether. Read on as we answer the most pressing capital gains questions sent to us by MoneySense readers.

Q. Can I avoid capital gains taxes by gifting assets to a family member?

Usually not, though you may be able to defer them. Normally, when you give assets such as stocks or property to someone, you trigger a “deemed disposition.” This means that even though you didn’t actually sell the asset (you just gave it to someone else) you’re on the hook for capital gains taxes as if you had sold it at its fair market value.

The one notable exception is gifting between spouses or common-law partners, which does not trigger a deemed disposition. But be aware of the Canada Revenue Agency’s attribution rules: when assets are gifted to a spouse, all interest, dividends and capital gains (or losses) are attributed back to the gifting spouse. So if you were to give $10,000 worth of shares to your husband, no tax would be payable immediately. But when he eventually sells them, you’d be responsible for any capital gains taxes due.

There is one way to legally avoid or reduce capital gains taxes if two spouses have a huge difference in income: the high-income earner can loan money to the low-income partner, who can use it to buy investments. (You must charge the CRA’s prescribed interest rate, which is currently 1%.) Unlike gifts, spousal loans do not trigger the attribution rules, so the low-income spouse will be responsible for paying any capital gains taxes at a lower rate.

Q. Can I use capital losses from past years to offset future capital gains?

Absolutely. If you realize a capital loss (by selling an asset for less than you paid for it) you can use that loss to reduce any capital gains you had on other assets that year. After that, you can use any remaining capital losses to offset gains you reported in any of the previous three years (you’ll need to submit a request to CRA).

Additionally, you can carry forward capital losses indefinitely, which means you can use them to reduce capital gains you might realize in the future. If your income is likely to be higher in later years, carrying your capital losses forward can be a smart move.

Say you’re a stay-at-home parent who plans to return to work, or you’re in the early years of retirement and haven’t yet started drawing down income from your pension, Old Age Security or RRSP. You might want to carry forward your capital losses for a while and use them to offset gains you will realize in future years when you’re in a higher tax bracket, so your tax savings will be greater. “Sometimes I encourage people to bank capital losses, even if they have capital gains, because they’re going to be in a higher tax bracket in the future,” says Jason Heath, a fee-only certified financial planner and income tax professional at Objective Financial Partners in Toronto. “If you can save $2 next year instead of $1 today it’s worth it to hold onto it.”

Q. Can I claim capital losses in my TFSA to offset gains in a non-registered account?

Nope. You can’t claim a capital loss on any investment held in a tax-free or tax-deferred account like a TFSA or an RRSP.

Q. Is there any way to get around the “superficial loss” rule?

To prevent investors from selling an asset to claim a capital loss and then buying it back right away, the CRA created the superficial loss rule. It applies when you claim a loss on a security and purchase “identical property” within 30 calendar days before or after the sale. For example, if you sold shares in Royal Bank at a loss and then bought more shares of the bank a week later, your capital loss would be denied. And don’t think you can have your spouse or someone affiliated with you (like a business partner) repurchase the same stock, either: the CRA will still disallow the loss.

Luckily, there is a way to legally avoid the superficial loss rule: You can repurchase a security that is similar, but not identical. For example, you could sell a Canadian equity ETF when it’s showing a loss and then buy another Canadian equity ETF that tracks a similar but not identical index. “That way you can realize a capital loss and still maintain similar exposure to Canadian stocks in your portfolio,” says Justin Bender, a portfolio manager at PWL Capital in Toronto.

Q. Is there any way to avoid capital gains entirely?

There are three ways to completely avoid capital gains—all of which are either unrealistic or unappealing.

The first is to become immortal and never sell your assets: dying, inconveniently, requires you to dispose of all your capital property (unless it transfers to your spouse with a tax-free rollover). A second strategy is to have an abysmal investment portfolio that never grows in value. Finally, you could earn little or no income, since the “basic personal amount” allows us to each earn about $11,000 a year without paying federal taxes.

As Toronto tax lawyer Eldad Gerb puts it, “If you’re avoiding capitals gains altogether, things are probably going pretty badly for you.”

There is one appealing way to avoid capital gains taxes, assuming you were planning on leaving a legacy. “You can donate capital property with unrealized gains to a registered charity,” says wills and estate planner Nathan Bender of Scotiatrust in Toronto. “The unrealized gains will be deemed to be nil and the donor would be entitled to the donation tax credit based on the fair market value of the property at the time of transfer.”

Q. If I buy and resell items at a profit, can I claim these as capital gains or is it business income?

Most people would prefer to claim these kinds of profits as capital gains, because they are taxed at only half the rate of business income. But the CRA is no fool: it will look at a host of factors to determine whether you’re just selling a few personal items or running a business. These include the frequency and volume of transactions, time frame between acquiring the item and its eventual sale, and the intention of the seller.

So if you’re routinely buying and reselling tchotchkes online, flipping houses or actively day-trading, it’s likely the CRA will view your activities as a business venture and therefore tax any gains on your “business inventory” as regular income. “Many similar online transactions scream business income,” says Gerb.

Q. How does the lifetime capital gains exemption work?

Anyone who owns a qualified small business (or a qualified farm or fishing property) is entitled to a $800,000 capital gains exemption upon the sale of shares. (Note that this figure applies to the entire capital gain, not just the taxable half.) “This is the government’s way of encouraging small businesses to grow,” says Heath.

This lifetime exemption, however, isn’t limited to one family member—a huge boon for small businesses that expect to incur far more than $800,000 in capital gains when they ultimately sell the shares.

That $800,000 figure can be claimed by any family member involved with the business provided they’ve held shares in the company for at least two years, says Gerb. So if a husband, wife and daughter each owned one-third of a family business, they would all be exempt—even if the sale of the business created $2.4 million in capital gains.

“It’s important to do some advance planning to not only ensure eligibility for the exemption, but to also make sure that company shares are transferred to family members earlier on.” With few exceptions, shares transfer to family members (or anyone else for that matter) at fair market value. So you should do this at or around the time of incorporation, when shares are likely to have minimal value.

Q. How does the principal residence exemption work?

The principal residence exemption can save you boatloads of money when you sell a residence you live in. The CRA allows you to claim any property you own in Canada and “ordinarily inhabit” as a principal residence—be that a house, cottage, condominium or even a trailer—and not pay any capital gains tax when it’s sold.

There are, however, a few caveats: spouses can only claim one principal residence between them, and the exemption is limited to the dwelling itself and half a hectare of adjoining land. But the definition of “ordinarily inhabits” is pretty liberal. Even a cottage you only use in the summer can qualify as a primary residence.

This is great news for families with multiple properties, because you can claim the property with the highest gain as your principal residence for any given period. Just keep in mind that you can only have one principal residence at a time.

Let’s say a husband and wife—Rob and Christa—own a home in Halifax and a cottage in nearby Mahone Bay, but they’re planning to relocate to another province. Waterfront property values on Nova Scotia’s south shore have skyrocketed, and Rob and Christa’s cottage has increased in value by more than their home. By claiming their cottage as their primary residence during this period, they will pocket all of the profit from its sale tax-free. Instead, they’ll pay taxes on the smaller price gain on their home in Halifax.

Q. Will capital gains taxes apply when I sell an inherited property?

Unless an inherited property is transferred to you by a spouse or common-law partner, a deemed disposition will occur, so the estate of the deceased person will pay any capital gains taxes owing. But if that inherited property was left to you by your deceased parents, it’s quite likely that most of the capital gains would be sheltered by the principal residence exemption, says Nathan Bender. “From that point on, any appreciation on the property would generally accrue to the adult child.”

In some instances, though, elderly parents may elect to add an adult child to their home’s deed while they’re still alive. This can help avoid future probate fees (an administration tax levied on a deceased taxpayer’s estate), and make it easier for the adult child to assume ownership. Just keep in mind that once your name is added to a deed (assuming you already have your own principal residence), you’ll be required to pay capital gains taxes in proportion to your percentage of ownership when the home is eventually sold. “People need to be cognizant of the fact that saving a little money on probate fees could results in lots more to be paid in capital gains,” says Heath.

For example, imagine a widow in Ottawa transfers 50% ownership of her $500,000 home to her adult daughter to save $7,000 in future probate fees. Ten years later, the widow and the daughter decide to sell the home, which over that decade has increased in value by $300,000. The daughter will have to pay half the capital gains due (unless she can claim the house as her principal residence), an amount far greater than $7,000.

Q. Is it true you can change your principal residence to a rental property without having to report capital gains?

Yes, but only if you don’t buy another residence to live in. By filling out the CRA’s “subsection 45(2) election” form you can claim the rental property as your principal residence and avoid paying capital gains on it for four years after you’ve left it, says Gerb. “It’s not well-known, but subsection 45(2) is an incredibly powerful tool. In limited circumstances related to employment relocation, it can even go beyond the four years.”

However, this election is only useful if you plan to rent after leaving your current home. If instead you buy another home and move into it while claiming the rental property as your principal residence, then you will expose yourself to capital gains taxes on the new home. “In that situation, it becomes an exercise in figuring out where you have more gains that warrant sheltering,” says Gerb.

ACB made as easy as 1 • 2 • 3

When you calculate a capital gain on an investment, it’s not enough to simply subtract your original purchase price from what you received from selling it. You also need to make certain adjustments for things like trading costs and reinvested distributions. Determining this “adjusted cost base” (ACB) can be a tedious and often complicated affair. But it needs to be done properly: otherwise you may wind up paying too much or too little in taxes.

The good news for mutual fund investors is that fund companies typically track your ACB for you. And if you buy and sell stocks through a discount brokerage, calculating the ACB and capital gain is usually straightforward. But if you’re enrolled in a dividend reinvestment plan (DRIP) and receive distributions in the form of new shares instead of cash, things get more complex. That’s because the ACB changes each time additional shares are bought.

For ETF investors, calculating the ACB is even more complex, because you’ll often have to account for the return of capital distributions (which lower your ACB) and reinvested capital gains (which increase it).

Don’t count on your brokerage to keep track of all of this for you. “Some may do a good job of calculating ACB—even with ETFs—but they sometimes make mistakes,” says MoneySense consulting editor Dan Bortolotti. “So you need to keep your own records and refer back to them.” Bottom line: It’s the responsibility of the investor to track the ACB.

While many investors use a homemade spreadsheet to track their ACB, several services can assist you. AdjustedCostBase.ca provides a free online tool for tracking your own ACB, while ACBTracking.ca will do the heavy lifting for a modest fee. But if your non-registered holdings are very complex, it’s probably best to hire an accountant.

16 comments on “Pay less capital gains tax

  1. Nice overview.

    One question that I think could be added to this is whether it is possible to transfer holdings from non-registered account to a registered variety, such us TFSA, and avoid paying capital gains taxes. The answer to this can be gleamed from this article, but it may be useful to certain readers to see this answered explicitly, and explained why this would not work :)

    Reply

    • Ireney, when you transfer holdings from a non-registered account to a registered account, a deemed disposition is triggered. This triggers the same capital gains liability as if you had sold the asset.

      Reply

  2. I have a property and bought a second property as a principal home last June 2014. I am wondering if I want to avoid capital gains tax on the first home that I’m planning to sell next June ( 1 year) how long is the window to avoid capital gains tax? I heared 1 year? Is it one year sharp?
    Could it also be avoidable even if the first home is rented?
    Thanks do much in advance for your reply.

    Reply

  3. Hi there,
    Had a question about renting out the primary residence, then selling it. I have been renting out my primary residence for 2 years and have used the forms mentioned above. I myself have been renting a another house but am ready to sell my property and buy something else. Do I need to move back into the primary residence before selling to avoid capital gains or since it is still my primary residence, am I ok?

    Thanks!
    Liza

    Reply

  4. My mother has passed away leaving her home to the 4 of us ; her children. My sister and myself ( we do not own homes) would like to buy out our other 2 siblings who own homes. How would the capital gains tax work for us and for them. Can the property be transferred to us to avoid our portion of the capital gains and how would by siblings capital gains tax be assessed.

    Reply

  5. I have a question. i bought a house for 90,000 and lived in it for 6 years. i that 6 year period i meet and married. we bought another home to move into and kept the first home for a rental. we rented that home for 6 years before selling it for 180,000. how do you calculate capital gain on that?

    Reply

  6. Dear Sir or Madam:
    I own a small investment business dealing with stocks and commodities. Do I qualify for a capital gains of $ 800,000 if I sell the business in the future?

    Reply

  7. My husband and I live in different provinces for work, unfortunately, so we live in separate houses. Yet, spouses can only claim one principal residence between them. Does it mean that we would have to pay capital gains on one of the houses? But they both are our principal residences! Does not seem fair…

    Reply

  8. We are seniors who own a cottage. We are selling our home, moving up to the cottage as our permanent residence and going to be vacationing in Florida over the winter months. Will capital gains have to be paid during later years when we are no longer able to vacation.

    Reply

  9. If I sell a small business and I’m set up as an LLC does the $800K exemption apply to me? I sold a business after 5 years and realized capital gains of about $350K and want to see what I can do to not be hit hard with gains this year. I plan to set up a new business and if it would help I can do that by the end of 2015. – THANKS

    Reply

  10. In addition to the ” basic personal amount ” of around $ 11,000 , can you also use other personal income tax credits to reduce your ” Capital Gains Tax “, if you have little or no income ?

    Reply

    • “But if that inherited property was left to you by your deceased parents, it’s quite likely that most of the capital gains would be sheltered by the principal residence exemption, says Nathan Bender. “From that point on, any appreciation on the property would generally accrue to the adult child.”

      What am I missing? The year a parent is deceased it triggers a deemed disposition on the principal residence and so the parent is not sheltered by the principal residence exemption and a child cannot defer payment the way a spouse can so how can the capital gains be sheltered by the principal residence exemption for a child? Thank you in advance for taking the time to explain.

      Reply

  11. My friend non resident Canadian citizen living in middle east. When he initially bought and sold his property the capital gain hold by the seller’s lawyer and released after providing the Certificate of Compliance.

    Now we both want to do a business in real estate (buy/sold). In this case is the same situation that capital gain will be hold till he provide Certificate of Compliance or it may released as we sold ?

    Reply

  12. can you use a capital loss on stocks sold to offset capital gains on rental property.

    Reply

    • Yes. That said, each situation is unique and you should seek the advice of a tax specialist before selling off depreciating stock in order to minimize capital gains from the sale of a property.

      Reply

  13. Hi,

    My inlaws are considering selling their house to my wife and I. They are recently retired and we are looking to enter into the housing market.

    They bought the Old house 20 years ago for $200 000. They lived in it for 10 years as their Principal Residence and have rented it out for the last ten years. They currently live in another New house as their Principal Residence that they bought ten years ago. The Old house is worth $800 000 at current market value. The Old house has had its mortgage paid for.

    My wife and I are trying to figure out what the most beneficial situation would be for both parties involved.

    The goal for everyone is to minimize all fees and taxes and transfer the title to my family. The inlaws especially want to minimize Capital Gain taxes.We are open to all methods/arrangements to make this work and not in a hurry to have the title of the house in our family’s name.

    What is your advice on Family and property sale?

    Reply

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