Capital gains tax going up, everyone panic! Well it isn’t that simple and there is a lot of confusion from people not using the right terminology.
The headline news is that starting June 25th 2024, capital gains will be taxed higher after the initial $250,000 in capital gain per year for individuals. The first $250,000/year in capital gain will have a capital gain inclusion rate of 50%. After the first $250,000/year the capital gain inclusion rate on any additional capital gain will be 66.67% (or 2/3). Note that for corporations and trusts, the capital gain inclusion rate for any capital gain will be 66.67% and this is quite a big change for those that own rental properties or reinvest excess cash within corporations.
For those who aren’t familiar with tax terminology or are confused and misled about what you’ve seen on social media, read on. Note that while some of it sounds very wordy and repetitive, you need to pay attention because there is a very important difference between capital gain and taxable capital gain and how these terms are related.
Stay until the end for some tax planning opportunities and considerations! As with any new legislation like this I also highly recommend you read the release from the government on this topic and have another example calculation.
Let’s start with defining some terms:
Capital Gain – To simplify, it is the profit you make after selling a capital asset; proceeds of disposition minus the cost of the asset. For example, if you could a rental house for $100,000 and you sold it for $500,000. Your capital gain will be $400,000.
Capital Gain Inclusion Rate – Currently (until June 25th 2024), the only capital gain inclusion rate is 50%. This means that 50% of the capital gain is included as taxable income.
Taxable Capital Gain – This is the amount of the capital gain that is actually taxed at your marginal tax rate. Using the above example with a Capital Gain Inclusion Rate of 50%, the taxable capital gain is $200,000. Note that $200,000 is the taxable capital gain and you are NOT paying the CRA $200,000.
Marginal Tax Rate – Canada has a progressive tax system which means that the more you make, the higher your tax rate. The marginal tax rate is the tax rate a taxpayer pays on their next dollar of income given their income level. In Canada it’s slightly complicated because we have federal and provincial tax rates which increase based on different levels of income. This is why most generic examples of tax calculations just assume the highest marginal tax rate to make examples easier. For example, in Ontario, the highest marginal tax rate in the 2023 tax year was 53.53% which applies to taxpayers making over $236,675 in taxable income. Using our example numbers above, assuming the taxpayer makes over $236,675, the applicable marginal tax rate on the taxable capital gain is 53.53%. Therefore the tax that is paid on the capital gain of $400,000 is $107,060.
Capital Gain Tax (?) – So what exactly is a Capital Gain Tax? There is no special tax rate for capital gains. In the above example, the effective tax rate on the capital gain was 26.76% (107,060/400,000) but an individual making $80,000 with a lower marginal tax rate (approximately 29.65% vs 53.53%) will result in lower effective tax rate on the same capital gain.* So when people say “the Capital Gains Tax has gone up!”, it can be confusing and misleading because there really isn’t one capital gains tax rate. What’s really happening is that the capital gain inclusion rate is going up after the initial $250,000 of capital gain.
Capital Gain Calculation from June 25th 2024
I will now use the above example to show you how to calculate how the new capital gain inclusion rate works. Reminder: Bought $100,000 house, sold for $500,000. We will use the same marginal tax rate of 53.53% in Ontario
Under the new tax regime, the capital gain does not change, it is still $400,000. But the capital gain inclusion rate will be different which results in a different taxable capital gain.
The first $250,000 has a capital gain inclusion rate of 50% therefore adding $125,000 (250,000*50%) of taxable capital gain to the taxpayers income.
The remaining $150,000 (400,000-250,000) of capital gain has a capital gain inclusion rate of 66.67% therefore adding $100,000 of taxable capital gain to the taxpayers income. This means that the total taxable capital gain will be $225,000.
Next step is to multiply the taxable capital gain by our marginal tax rate of 53.53% resulting in a tax of $120,442.50 on the capital gain of $400,000. The result is that under the new system, the same transaction would be taxed an additional $13,382.50. If you want to boil it down, it is essentially a 16.67% tax increase on capital gains above $250,000/year for individuals and 16.67% tax increase on all capital gains for corporations and trusts.
Main Takeaways
Most people will not be affected by this because A) their main asset is their own home which is exempt from capital gains under the Principal Residence Exemption and B) if they are selling an investment/rental property, only gains above $250,000 will be affected.
The most affected will be on corporations and trusts which will see all their capital gains subject to the 66.67% capital gain inclusion rate.
Tax Planning Opportunities?
Here are some options for reducing your tax burden with the higher capital gain inclusion rate:
- For real estate held in a corporation, it is worth rethinking why you are holding it in a corporation. If it is simply for limited liability, is it worth paying an additional 16.67% in taxes for capital gains in a future disposition? It might be worth taking the property out of the corporation to be held personally.
- For professional corporations and other businesses that reinvest profits within a corporation to take advantage of tax deferral; this new change can have an impact on the cost-benefit analysis especially if you are generating a lot of capital gains within the corporation. It might be worth taking more dividends out of the corporation and investing personally. This is especially true if you are planning to liquidate holdings of the corporation in the next few years for retirement or sale of the business to take advantage of the Lifetime Capital Gain Exemption.
- In the future, you would want to keep capital gains below $250,000/year to avoid the higher inclusion rate. For most people such a big gain would mainly be from the sale of an asset like an investment/rental property. Obviously, such a disposition is very difficult to split up into multiple transactions. But in the right circumstances, you could sell a percentage of the property each year to get below the $250,000 cap. You would obviously be incurring additional transaction fees and complications, especially if the property is mortgaged. But in the above example with a $400,000 capital gain, if you split the transaction over two years, you would save $13,382.50 in taxes.
Given the fact that the effective date of this new change is June 25th 2024, this does not give you much time to make substantial changes to your asset holdings so please reach out to us ASAP if you want a consultation.
FAQ
- The new capital inclusion rate will apply to assets sold on or after June 25th 2024. For real estate this means that any Agreement of Purchase and Sale that becomes binding on or after June 25th 2024 will have the new capital gain inclusion rate. To avoid the new capital inclusion rate you would need to having an binding APS before June 25th 2024.
- Corporations and Trusts will effectively be paying 16.67% (66.67%-50%) more in taxes on capital gains across the board because the new capital gain inclusion rate applies to any capital gain.
- The principal residence exemption still applies.
- The $250,000 threshold for individuals resets each tax year
*I have omitted calculating the effective tax rate as it is more difficult because the taxable capital gain will be taxed at different marginal tax rates as it pushes up the taxable income