Capital gains tax on large transactions is set to increase, thanks to the recent federal budget, but not until June 25, 2024. So, there’s still time to act – depending on your situation.
The change in Canadian capital gains taxation has prompted a flurry of analysis among investors and real-property owners who have substantial unrealized capital gains on their books to decide if they should execute a quick sale of assets (thus “crystalizing” gains) to save taxes.
The current rules require that one-half of capital gains be included in income for taxation purposes. As of June 25, while that inclusion rate remains in place for gains of up to $250,000 realized on the sale of assets during a year in total, two-thirds of gains beyond that level will become taxable. For trusts and corporations, two-thirds of all gains realized will become taxable as of that date; there is no $250,000 threshold.
For many investors in securities or real estate, unless one is looking at a significant windfall, doing nothing is probably the best route, tax experts say. But in some cases, analyzing a situation is worthwhile. “Even a middle-income earner can have years in which they realize a large enough gain on their rental property, cottage, or stock options that would be impacted by the proposed changes,” says Sonia Ghandi, National Leader, Global Mobility Services & Immigration, KPMG in Canada.
When to Sell with the New Capital Gains Rules
If you anticipate a profit well in excess of $250,000, you may want to act on selling assets. This typically might involve assets such as real estate that isn’t your principal residence (the sale of which continues to be tax-free). So, if you are contemplating the sale of a valuable second home that you have owned for a long time – or transferring ownership to a younger family generation – it may be worth making this happen before June 25.
In pure dollar terms, the argument for realizing a gain now in order to save tax can be compelling. If, for example, one is looking at a profit of $600,000 on a property sale, one-half of the first $250,000 of that gain, or $125,000, will be taxable. However, two-thirds of the $350,000 balance, or $233,450, will now be taxable, as opposed to $175,000 under the existing rules. For someone in the top income-tax bracket, the higher inclusion rate would result in additional tax as high as $30,000 or more, depending on the province of residence.
However, basing a decision purely on potential tax savings may not be wise, Ghandi says. “There can be a present value cost to accelerating taxation,” in terms of abandoning a long-term tax deferral by retaining a capital investment,” she says, “as well as potentially an actual cost in interest if loans are taken out to cover the tax bill.”
Why You Might Not Want to Sell Just Yet
When it comes to the sale of a cottage or other second home, which you do not eventually anticipate sheltering under the principal residence exemption, factors beyond taxation need to be considered. In other words, engineering a fast sale to escape the higher capital gains rate probably is only prudent if you have already sorted out issues of succession and value.
“Unless you had already decided you were going to sell, the budget announcement on its own shouldn’t change anyone’s plans,” says Peter Guay, a portfolio manager with PWL Capital Inc., “There are too many other considerations to let tax be the sole driver of the decision.” These considerations could include no longer being able to enjoy the property, abandoning future gains in property value, and loss of tax deferral through continuing ownership.
A potential reason to act now would be to go ahead with a previously planned transfer of ownership to your adult children or grandchildren. But, in all cases before selling or transferring a residence, “it’s important to first run an analysis on how best to use your principal residence exemption between your cottage property and your other home,” Guay says.
For those who own more than one home, regardless of how much time is spent in a location, you can select which property to designate as a principal residence. What’s more, you can decide under which time frames to designate a particular property as such. These are decisions that would be made depending on a property’s increases in value during specific periods. This can require a lot of analysis and consulting municipal valuations over time for each property.
Consider Splitting Up the Sale Instead
If you have a buyer for your property and your capital-gains-tax liability is substantial, consider taking the proceeds in separate payments over the next few years. This can be done using a mechanism known as the capital-gains reserve, which permits you to receive and report income from a sale in equal amounts for up to five years. These reserve amounts must be “reasonable” in the eyes of the tax man. Note that the reserve can only be used for an actual cash sale and does not apply to property transferred to a younger generation.
Transferring ownership to your spouse can be done on a tax-deferred basis, meaning capital gains tax would not be payable until that spouse dies or sells the property. At that time, the tax would be based on the entire gain dating back to when the property was acquired by the spouse who originally acquired the property.
The looming higher inclusion rate could prompt a re-think of estate planning, says KMPG’s Ghandi, although not necessarily when a spouse is the sole beneficiary. “If the assets will be transferred to a spouse after death, the capital gain will be deferred,” she says. “In other cases, a sale of a significant amount of marketable securities before June 25 would be more tax effective. However, challenges arise where the person’s wealth is derived from illiquid assets, such as private company shares,” because time is needed to place a value on shares and to find a buyer.
A deceased person’s assets are taxed as a trust, and thus the lower 50% inclusion rate for the first $250,000 of gains does not apply. As a trust assumes a recent cost base for those assets that is equal to their value on death; “the trust would only be taxable on post-death growth. If the trust realizes future gains and does not allocate the gains to a beneficiary, the trust would be subject to a two-thirds inclusion rate,” Ghandi says.
When to Move the Cottage to a Trust in Canada
At some point, for succession-planning purposes, some recreational property owners consider transferring the property to a trust: “If you are later in life, and the gain on the property is not yet very large, and you’re certain that your children or grandchildren want to keep the property in the family, it might be interesting to consider moving the cottage into a trust now,” says PWL’s Guay.
“But there’s a lot to consider in this decision beyond just the taxation aspect, particularly since the tax filings for trusts have become much more onerous in the last few years,” Guay says. “Moreover, trusts created during your lifetime -- as opposed to one created through your will -- have a 21-year lifespan, before which the cottage would have to be spun out of the trust to the beneficiaries, or the gain would be taxed if left in the trust. For this reason, you typically don’t consider a trust unless you are into your 70s.”
A significant capital gain can sometimes attract alternative minimum tax (AMT) for high-income taxpayers. However, the 2023 federal budget – which is yet to be brought into law -- proposed an increase in the AMT inclusion rate for capital gains. “This would increase the risk that a significant gain is realized in 2024 or later would trigger an AMT liability, which may or may not be recoverable in the future,” says Ghandi. “The 2024 budget’s proposed increase in the tax capital-gains-inclusion rate actually reduces the risk that a gain would trigger AMT tax, as the spread between AMT tax and regular tax could now be narrower.”
