A simple guide to understanding the basics of capital gains.
When buying and selling stocks, there’s more to consider than returns. Capital gains should be an important part of your decision-making as they can impact your final tax bill. Very few will sit by an open fire reading about capital gains in the Income Tax Act. But knowing some of the ground rules when it comes will definitely benefit you come tax time. Let’s dig in.
How are stocks taxed in Canada?
Determining whether you’re a day trader or investor will have a big impact on how much you pay in taxes. The CRA’s superficial loss rule is a tool it uses to prevent day traders and others from taking part in transactions with the specific goal of realizing capital losses on stocks, only to buy back the same stock immediately afterward. As the name implies, the rule refers to the 30 days before the day of the stock sale transaction, and the 30 days that follow the transaction.
If you’re a day trader
Day trading, in the eyes of the CRA, is defined as making a living by buying and selling securities. In other words, it’s a full-time job. Determing if one is a day trader involves criteria such as how frequently you trade, how long you hold equities, and other factors. If you’re a day trader, 100% of your profits will be considered business income, and taxed at your current tax rate.
If you’re an investor
When you buy and sell equities as investments, you’re considered an investor and can report any profits as capital gains (or, conversely, capital losses) on your taxes. In Canada, 50% of capital gains are taxed at your marginal tax rate.
What is the capital gains tax rate? How much is it?
In Canada, only 50% of the capital gain you “realize” on stocks is taxed – the other 50% is yours to keep tax-free. The final dollar amount you’ll pay will depend on how much capital gain you realized and your tax bracket.
Here’s an example:
Joan is in Ontario’s highest tax bracket of 53.53%. She purchased $2500 worth of stock, and then sold it for $3500. Her profit, or the amount of capital gain realized, is $1000. Joan must pay the capital gains tax on 50% of this amount, or $267.65.
By the way, in addition to capital gains, there are two other types of investment income: interest and dividend income, which we’ll compare side-by-side in a bit. Each one is taxed differently but capital gains is by the far the most advantageous from a tax perspective.
Capital gains realized in foreign currencies must be reported in Canadian dollars, as do the date of your purchase and date of sale.
What is a capital gain or capital loss?
As mentioned earlier, a capital gain is the profit an investor makes from the sale of stocks. Capital gains are only “realized” when you sell your stocks. Capital gains also apply to mutual funds and exchange-traded funds (ETFs) because they are made up of shares, although they distribute returns in different ways.
“Unrealized” capital gain is when the value of stock has increased but you haven’tsold it. Capital gain taxes only kick in when you sell your stock. Until you do, there is no capital gains tax owing.
A capital loss occurs when you sell stock for less than you paid for it. When claimed in your income tax return, capital losses may only be used to offset capital gains. The Canada Revenue Agency (CRA) doesn’t treat all capital losses the same way. There are different rules applied to different types of capital losses. Capital losses are eligible to be carried back for three years or carried forward indefinitely.
How to calculate capital gains or capital losses
The very first step to calculating capital gains or capital losses is determining the Adjusted Cost Base (ACB or ACBS). From there you can figure out the amount of taxable capital gains.
- Determine the Adjusted Cost Base
Book value of your stock (the original purchase price), plus any costs to buy it, like brokerage fees.
- Calculate the Capital Gain Subject to Tax
Selling price of stock (less any fees) minus the Adjusted Cost Base amount above.
Here’s an example of these equations in action:
Rahim purchased 200 shares of ABC Corp at $5.00 each for a cost of $1000. He paid a $10 commission fee to his brokerage, for a total ACB of $1010. He sold his shares a month later for $6.50 each and paid a $10 commission fee for a total of $1290. Rahim’s capital gain on 200 shares of ABC Corp was $.280 (payoff less fees and less ACB)
How to reduce your capital gain taxes
A well-balanced investment portfolio will likely enable you to benefit from potentially lower tax rates on capital gains while offering some level of protection from higher-taxed interest income. Here are some strategies worth considering.
Tax loss harvesting reaps good outcomes
Believe it or not, the Canadian Revenue Agency allows you to offset your capital gains with your capital losses to help reduce your tax bill. “Tax loss harvesting” is the strategy of selling under-performing funds to generate a capital loss that offsets your capital gain. You can use capital losses to offset capital gains from the previous three years, plus capital losses can be carried forward indefinitely . There are time limits and other rules, so you’ll want to fully research this strategy.
Use tax-advantaged accounts to your benefit
Not all accounts are taxed the same way! That’s why you should take different approaches when investing in registered and non-registered accounts.
Because capital gains receive preferential tax treatment over interest income or dividend income, it may be more advantageous to hold these growth-oriented shares, stocks and mutual funds in non-registered accounts.
Registered accounts, such as Registered Retirement Savings Plan/RRSP, RRSP, RRIF, are tax-sheltered, potentially making them ideal for investments that pay interest or dividends, as these are taxed at higher rates. Earnings are only taxable when they are withdrawn from the accounts. Examples are fixed-income and money market and fixed-income investment vehicles. Keep in mind, when withdrawing from these registered plans (excluding a Tax Free Savings Account) the withdrawal amount will be included as income for income tax purposes.
Capital gains, interest and dividends earned on investments in a tax-free savings accounts, or TFSAs, are typically not taxable while held in the account or when withdrawn.
Consider the implications of holding riskier investments in a registered account such as an RRSP: if, for instance, stocks decrease in value, that may directly impact your retirement. Additionally, because they’re in a registered account, tax loss harvesting strategies will be unavailable.
Capital gains, interest and dividends: How do they compare?
|Distribution type||What’s the tax treatment?|
Adjusted Cost Base (the amount you paid, plus
additional costs, such as brokerage fees)
|50% of a capital gain is taxable|
Canadian Dividend Income
Payments made by Canadian public corporations to
|Preferential tax treatment for either eligible or non-eligible dividend tax credits|
Earned on bonds, T-bills, GICs and others
|Taxable at the same marginal tax rate as ordinary income|
Capital gain tax and day traders.
If you’re a day trader (or professional investor) that makes your living buying and selling stock – it’s essentially your full-time job – you may not be illegible to claim capital gains.
In fact, your gains may not be considered gains at all by the Canadian Revenue Agency. They’ll be considered business income!
Investing the right way: Use capital gains to your advantage.
Decisions have consequences – and tax consequences, too! Understanding the tax implication of every investment decision you make is a critical skill. One that will help you minimize your taxes and maximize the potential of your investment portfolio.