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Over the last year, there has been considerable speculation (like most other things these days) about the Federal Government increasing the inclusion rate of capital gains tax in Canada. Although the concept of capital gains tax is not new to Canadians, there have been several changes to the rate of taxation since its introduction in 1972. When the tax was first introduced to Canada, the inclusion rate was 50%. This increased to 75% in 1990 and was then reduced back to 50% in 2000, where it has remained for the last 20 years. So, if it has remained steady all these years, you might be asking yourself, why should I care now? The answer to that question, and many others, will be explained throughout the contents of this article.
The main purpose of this article is to educate property owners about how an increase in the capital gains inclusion rate would affect you in the future. This should also warrant a review of tax strategies and whether it is worth it to plan ahead of the increase in the capital gains inclusion rate. Before we get into that, let’s take a look and when Capital Gains Tax occurs.
Unlike your typical business income, a capital gain most commonly arises when you sell capital property and realize a gain. Capital property can consist of many capital assets that have the ability to generate rents from real estate, business profits, interest, dividends, royalties, etc. The Canada Revenue Agency defines capital property as:
Depreciable property, and any property which, if sold, would result in a capital gain or a capital loss. You usually buy it for investment purposes or to earn income. Capital property does not include the trading assets of a business, such as inventory. Some common types of capital property include:
From a calculation perspective, a capital gain is calculated by taking the difference between the proceeds of disposition and the adjusted cost base of the capital property, less outlays and expenses. All of these terms are defined in the Income Tax Act, but for the purpose of this article, we have summarized them in simpler terms below.
The proceeds of disposition is generally calculated using the sale price of the capital property. The adjusted cost base of the capital property is typically your original cost and, in the case of rental properties, any additions and improvements you have made to your property. The outlays and expenses are any costs incurred on the sale, such as commissions, legal costs and other selling expenditures.
Now that we have covered when capital gains occur and how it is calculated, let’s take a look at how an increase of the inclusion rate would affect your taxes owed.
Below you will find an illustration of the difference on a capital gain of $100 under a 50% inclusion rate compared to the hypothetical increase to 75%:
The above illustration assumes the proceeds of disposition to be $200, with a capital gain of $100. As you can see, the end result shows that the increase in the capital gains inclusion rate to 75% increases the overall taxes by $13.38. In other words, for every $100 of capital gains generated on a sale or a disposition, there is an additional $13.38 of tax owed.
For the illustration above, we have ignored the calculation of recapture of capital cost allowance as that is beyond the scope of this article. At a very high level, you may claim an annual capital cost allowance (i.e. depreciation for tax purposes) for your cost of the property, including any additions and improvements. The undepreciated balance is called undepreciated capital cost. Recapture of capital cost allowance happens when the proceeds of disposition exceed the undepreciated capital cost (depreciated balance for tax purposes). Please consult your professional tax advisor if this is applicable to you.
With the potential increase of the inclusion rate looming, there is no time like the present to start planning for the future. With that in mind, we have listed a few simple planning considerations and strategies that you could undertake with your professional advisors. As there are many different planning tips and different variations of tax strategies, it is never a one-size fits all situation and we encourage you to seek advice from a professional. Many of the points below have been tailored for Canadian real estate owners and is not an exhaustive list of points. If you would like to discuss your specific scenario, our tax advisors at Smythe are available and educated on the latest changes and regulations.
If you are planning on selling your real estate portfolio in the near future, you may want to consider closing your sale sooner rather than later, to realize a capital gain under the current 50% inclusion rate to avoid the potential increase to 75%. With that said, a general rule of thumb is to not allow tax changes to drive your business decisions. While tax strategies are an important factor to consider when running your business, we always recommend that decisions made in regard to your business should drive the decisions you make regarding your taxes, not the other way around.
In some situations, it may make sense to structure the sale or transfer of property now, in order to trigger a capital gain. For example if there is a sale expected in the near future it may make sense to consider structuring a sale to a holding company or another company in order to trigger a capital gain early. Even if you are selling to your holding company or another company of yours, the transfer or sale would occur at fair market value which would trigger a capital gain. Additionally, if you have an estate plan with intergenerational plans, you could potentially gift your assets early to trigger capital gains now, rather than at a higher inclusion. In both cases, there will be taxes owing and if the taxes are significant, you should plan on how you will finance repaying them.
Although these are just some examples of how capital gains could be triggered, the examples and potential planning opportunities described above are highly complex and we recommend that you consult a professional tax advisor before acting on them.
To conclude, we want to once again emphasize that the contents of this article are based on speculation that the capital gains inclusion rate will increase, and not on actual facts. For now, we are all patiently waiting for the Federal Government to announce any changes during the 2021 federal budget announcement. Until then, you and your professional tax advisors should discuss whether or not it is worth planning and strategizing in advance to hopefully minimize capital gains taxes in the future.
The information provided is a general overview and should not be construed as tax advice. We recommend seeking professional advice from a tax advisor in respect of your specific situation.
Daniel Lai is a partner at Smythe LLP (Smythe) and leads the Firm’s Real Estate and Construction Group. Smythe is a BC-based Chartered Professional Accounting firm with proven expertise and over 40 years of experience providing accounting, tax and business advisory services to their wealth of real estate and construction clients across Canada. Their experience with real estate owners, investors, developers and construction companies allows them to tailor their services to meet their client’s specific needs.
If you would like to discuss the contents of this article or are curious about how this potential change might affect your business, please contact Daniel directly via email at email@example.com or by phone at (604) 694-7531. For more information about Smythe’s experience in the real estate and construction industry, click here or contact them directly for any other questions.