Almost everyone tells you that you can build wealth by investing in the financial or real estate markets. While this is great, only a few people remind you that you need to pay taxes on your investment gains.
Paying taxes on your capital gains should not deter you from investing, given that only some of your gains are taxed, and you get to build wealth through your investments anyway.
What are Capital Gains?
When you sell your investment assets, such as real estate properties, share units in a company, or investments in a flow-through entity, such as REITs, MICs, and mortgage funds, you can make capital gains.
A capital gain occurs when you sell your investment asset at a higher price than the purchase cost of the asset.
The Canada Revenue Agency, also known as the CRA, uses an adjusted cost basis to determine your capital gains. In simple terms, the adjusted cost basis considers the selling and acquisition costs of your assets, such as fees and commissions. Such costs reduce whatever capital gains you have to report.
Here’s a simple example:
Assume you purchased share units for $500 and sold them for $1,000. If you paid a commission of $50 to sell your assets, your capital gains would be calculated as follows:
($1,000 – $50) – $500 = $450
Capital gains can be realized or unrealized. Realized capital gains occur when you sell or dispose of your investment asset. On the other hand, unrealized capital gains are just gains from an increase in the value of assets you own.
CRA does not tax unrealized gains. When filing your taxes, you only need to report capital gains if you sell or transfer your investment asset.
How Capital Gains Taxes Work
Don’t worry about giving up all your capital gains to the government. Only half of your capital gains get taxed. For example, if you make $1,000 capital gains when you sell your investments, you only need to pay taxes on half the gains, which is $500.
The CRA will apply your marginal tax rate on your gains. If your tax rate is 20%, your estimated taxes on your $1,000 capital gains will be about 20% x $500, which is $100.
How To Avoid or Reduce Taxes on Capital Gains
One thing is for sure; the CRA is coming for any gains you make on your investments. However, you can defer or avoid taxes if you invest in a registered account.
Registered accounts that allow you to defer or avoid taxes on capital gains are the tax-free savings account (TFSA), registered retirement savings plan (RRSP), and registered education savings plan (RESP).
Investing in registered accounts is limited to allowable investment assets such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, guaranteed investment certificates (GICs), and real estate investment trusts (REITs).
If you make capital gains in your tax-free savings account, the CRA will let you keep your gains tax-free. For example, if you purchased stocks for $1,000 in your TFSA, and after a year, you sell your stocks at an increased value of $1,500, you will not pay taxes on the $500 gains.
The CRA will not tax your capital gains in other registered accounts, such as the RRSP and RESP, provided they remain in your accounts. When you withdraw the gains from your account, the CRA will apply the applicable tax rate on 50 percent of your capital gains.
Other ways to reduce your taxes on capital gains are by offsetting your gains with capital losses or selling off a primary residence property.
In summary, disposing of your investments can lead to taxable gains or losses. The CRA requires you to report your capital gains and pay taxes on half of your gains. You can delay paying taxes on your capital gains or avoid them entirely if you hold your investments in registered accounts.
Capital gains tax can be complicated if you hold many investment assets. Always consult a tax specialist or financial advisor to help plan for investment taxes.