Capital Gains

Capital gains earnings result when capital property, other than personal property or inventory, is sold for an amount greater than that at which it was acquired.  Think of an investment as an example.  When this type of property increases in value it will result in a capital gain. Conversely, if a taxpayer sells such property for less than their original cost of the property, they in turn have a capital loss.

 

When the taxpayer sells capital property which has been depreciated for more than the depreciated book value (referred to as the “undepreciated capital cost” or UCC), the amount above the UCC is included in income.  Additionally, depreciated property that sells for less than its UCC allows the taxpayer to deduct on account of income the proceeds of sale below its UCC.

 

The major difference between income tax and capital gains tax is that every dollar of income that one earns will be taxed.  However only half of one’s capital gain is taxed.

 

Capital gains tax is in place for a few important reasons. Most importantly it ensures that tax is payable no matter how one earns their money.

 

Most often Canadians encounter capital gains in the context of real estate transactions and investments.  And there is a very important exception to capital gains in the case of one’s principal residence.  If one were to sell their principal residence for more than they paid, although there is technically a capital gain, the “principal residence exemption” ensures that no tax is payable on the gain.  The same is not true if one were to make a gain on the sale of a rental property for example.

 

Given that only half of a capital gain is taxable one can see why it would be beneficial to have their income characterized as a capital gain rather than business income.  This characterization becomes a contentious issue especially in the context of investments and real estate.

 

With respect to investments, if one were to purchase stocks and hold them for a long time and sell them afterwards, it could easily be argued that the gain is a capital gain and that only half of the gain is taxable.  However, if somebody’s job is to trade stocks (think of a day trader for example), and they spend their time buying and selling stocks, it could easily be argued by the CRA that the profit from buying and selling of stocks is not actually a capital gain, but rather business income as the taxpayer is engaged consistently in the activity of purchasing and selling stocks.

 

The same situation exists with real estate.  If one were to purchase a rental house and rent it out and then sell it years later, the odds are that the CRA would consider the profit to be a capital gain.  However, if one is engaged in the purchase and sale of properties on a regular and ongoing basis (think of a house flipper), the odds are that they would categorize the profit generated as business income.

 

Although the Income Tax Act does not provide guidance to help determining whether profit made on a real estate transaction constitutes business income or a capital gain, the courts have provided factors that they will consider in making that determination. The Canadian Revenue Agency (“CRA”) will consider the same factors in assessing your tax position. Some of these factors include: the taxpayer’s intention at the time the property was purchased, whether that intention was carried out, whether the taxpayer is in the business of buying and selling real estate, among various other factors. The full list of considerations is in the CRA’s Interpretation Bulletin, 218R.

 

Besides investments and real estate, another common area where capital gains are encountered is in the context of selling one’s business.  The shares of one’s business are considered to be capital property.  If the business increases in value and those shares are sold, a capital gains arises, half of which is taxable.  And if one’s business is considered to be a Qualified Small Business Corporation (“QSBC”), there is a further capital gains exemption which is available to be used by a taxpayer once in their lifetime.  This “Lifetime Capital Gains Exemption” allows a taxpayer to earn $892,218 of capital gains from the sale of QSBC shares without having to pay tax on it.  And this number increases each year as it is indexed with inflation.

 

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