Tax rates likely to rise: what to do about it

By Eva Khabas

Special to the Financial Independence Hub 

The Covid pandemic has led to unprecedented government spending with a deficit that has reached record heights.

Sooner or later someone has to pay for this and that usually means the taxpayer. Don’t look now but when you start your tax planning it’s probably best to assume that tax rates are going up in Canada.

However, even before Covid the federal government was talking about increasing the capital gains tax.

Capital gains inclusion rate could go back up to 75%

Currently, only 50% of capital gains are, in fact, taxable but this was not always the case. In fact, from 1990 to 1999 75% of capital gains were subject to tax! It’s logical to assume that tax revenues will be increased through a higher capital gains portion that is taxable, since capital gains are perceived as ‘passive’ income from investments. In theory, this means taxes should be generated by wealthier taxpayers.

Loss of Principal Residence exemption?

Also, the big fear of every Canadian is that government will remove the principal-residency exemption. Currently, taxpayers can sell their primary residence at a gain and not pay any taxes.  Many taxpayers rely on the appreciation in value of their homes as their main source of retirement income. The impact of making gains on principal residency taxable would be devastating to many, if not most, Canadians.

Before discussing what to do about all this, let’s make sure we understand what capital gains are, how they are different from your other income, and when these gains become taxable.

So, what exactly is capital gain? In a nutshell it’s the growth in the value of an asset being held for investment purposes, so that asset is not for resale. A long-term holding period would indicate that the gain is capital. Currently, only half of the capital gain is taxable, while most other income is fully taxed.

In most cases the capital gain is subject to tax when the asset is sold, but there are also times when you may have to report capital gains without an actual sale occurring. For example, at the time of death there is the deemed or assumed sale of all assets, with any capital gains included in the tax return of the deceased. This would, of course, affect beneficiaries.

It’s important to note that increases in personal tax rates will also result in you paying more tax on capital gains. This is because the tax rate on capital gains is applied at the same tax rates in Canada as on employment and other income. In addition, reporting a higher overall total income would also result in more tax because a higher income puts you in the top tax bracket.

Defence # 1: Timing

So, now we see that many tax-reducing strategies primarily revolve around two things – 1) timing, and 2) reducing your taxable income. First, let’s look at timing.

If you have higher overall income from various sources in 2021, and expect lower taxable income for 2022, consider disposing of the asset(s) in 2022 wherever possible so the gain attracts a lower marginal tax rate for you.

You can also use time to advantage by deferring the cash outflow – the tax you pay to the government – and disposing the assets early in the year. Your tax bill is due April 30^th of the following year, so if you sell the capital asset in January of 2022 you still have 15 months until tax must be paid on that.

Staggering gains over multiple years

Now, let’s assume you have a large capital gain. How can you stagger that gain over several years? One strategy is to defer cash receipts from the sale over multiple years. The Canadian Income Tax Act allows you to spread that gain over five years (and in some cases over ten years), provided you receive proceeds from the sale over a number of years. For example, if you receive 20% of the proceeds in 2021, you only need to include 20% of the gain in your taxable income as it can be spread over five years.

RRSPs and TFSAs

All these strategies are of a short-term nature. If the assets are disposed of in the long term, consider holding them inside your RRSP. You don’t have to declare those assets as income until you make a withdrawal. Likewise, you can use your TFSA so some of the gains are not subject to tax at all. Either way, your tax advisor can help determine if assets can be transferred to your RRSP or TFSA.

As for a long-term perspective, if tax rates are expected to increase – and they are – consider shifting your income to years with lower tax rates by declaring capital gains sooner, while still keeping beneficial ownership of the asset (i.e., continuing to enjoy the use of the asset). This means less tax is payable now on the same amount versus later when tax rates are higher. Doing this involves more complex strategies so, once again, it’s best to consult your professional advisors – accountant, tax lawyer, or others.

If you are concerned about the exemption for your principal residency disappearing and we should consider that very likely to happen, here is one possible strategy. Sell the existing residence and buy a new residence at the current market value. This way any existing appreciation is sheltered from tax. However, as we all know, buying and selling real estate comes with significant transaction costs that must also be considered in your tax planning.

Defence # 2: Reduce your taxable base

Now let’s look at the second pillar of your tax-planning strategy, namely, how to reduce your taxable base. The obvious consideration here is to claim all applicable costs allowed in order to reduce your capital gains. In the case of stock investments, carrying charges are allowed. In the case of a real estate sale, remember that deductible expenses include the fees paid to both the real estate agent and lawyer.

Another way to reduce your taxable base is by triggering losses on other assets to reduce your taxable gains. Once again, this is an area where you should involve your tax advisor so as to avoid such issues as superficial losses. Those losses may be denied.

Income Splitting

Also, consider income-splitting but again keep in mind that your tax advisor should be involved because the rules can be quite complicated and there are always new ones being thrown into the mix. For example, Tax on Split Income (TOSI) rules became effective in 2019 and required some revisions to existing tax plans.

There is a separate tax advantage available to business owners who are selling shares of qualified small-business corporations and this can be significant  since a large portion is exempt of tax – provided all the rules are met. For example, on a sale of shares in 2020 that qualify for this exemption, the maximum amount that can be realized tax-free is $ 883,384. This amount is indexed for inflation every year.

In conclusion, while minimizing taxes is always preferred, one should always consider non-tax considerations, such as cash-flow needs, risk tolerance, and other things. And as tax rules continue to evolve and become increasingly more complex, be sure to utilize your tax advisor to plan your strategy properly.

Eva Khabas is an accountant who runs Tax By CPA (www.taxbycpa.ca). Her areas of expertise include Canadian and U.S. taxation, tax planning, and audits. She handles complex issues for clients who have foreign interests, especially in the U.S., and provides services for foreign companies operating in Canada – everything from compliance with the CRA and IRS to tax treaties, implications of withholding tax, and buying and selling property.