Capital Gains and Losses

Introduction to Capital Gains

Capital gains arise from the disposition of capital assets and are subject to specific tax rules in Canada. It is important to distinguish between capital transactions and business income, as the latter is treated differently for tax purposes.

• Capital Asset Disposition: Includes sales, redemptions, expirations, cancellations, conversions, transfers to trusts, expropriations, and gifts (deemed disposition at fair market value).

• Preferential Tax Treatment: Capital gains receive more favorable tax treatment compared to other income sources such as employment, business, or property income.

• Taxpayer Incentive: There is a strong incentive for taxpayers to classify transactions as capital asset sales to benefit from preferential rates.

History of Capital Gains Taxation in Canada

Capital gains taxation has evolved over time, with changes in the inclusion rate affecting the amount of gain subject to tax.

• Pre-1972: Capital gains were not taxed; only other income sources were taxable.

• ITA 3(b): Requires net taxable capital gains to be included in Net Income for Tax Purposes.

• Inclusion Rate Changes:

  • 50% (1972–1987)

  • 67% (1988–1989)

  • 75% (1990–Feb 27, 2000)

  • 67% (Feb 28, 2000–Oct 17, 2000)

  • 50% (Oct 18, 2000–present)

Types of Dispositions

Dispositions refer to the various ways capital assets can be transferred or sold, as defined by ITA 248(1).

• Means of Disposition: Sold, redeemed, expired, cancelled, converted, transferred to a trust, expropriated.

• Deemed Dispositions: Occur due to change in use, gifts (deemed proceeds at fair market value per ITA 69).

Calculation of Capital Gains and Losses

The calculation of capital gains or losses involves several steps and adjustments.

• Formula:

• Inclusion Rate: Currently 50%.

• Allowable Capital Loss: Only 50% of capital losses are deductible against taxable capital gains.

Selling Costs

Costs incurred to dispose of a capital asset are deductible when calculating the capital gain or loss (ITA 40(1)).

• Examples: Legal fees, broker fees, real estate fees.

• CCA Purposes: Net proceeds (proceeds minus costs of disposition) are used for Capital Cost Allowance calculations.

Adjusted Cost Base (ACB)

The adjusted cost base is the original cost of the asset, adjusted for certain factors, and is used to determine the capital gain or loss.

• General Rule: ACB is usually the same as the accounting cost.

• Depreciable Assets: For these, ACB equals the capital cost (ITA 54).

Mutual Funds and Dividend Reinvestment Plans (DRIPs)

• Income earned and automatically reinvested increases the ACB.

• Taxes must be paid on reinvested income, and the full amount reinvested is added to the cost of the funds or shares.

• Example: If a dividend is reinvested, the pre-tax amount is added to the ACB.

Superficial Loss

• A superficial loss occurs when identical property is purchased within 30 days before or after the sale (ITA 54).

• Such losses are denied and added to the ACB of the repurchased property (ITA 53(1)(f)).

• This adjustment lowers future capital gains and results in the same taxable income impact over the property's life.

Identical Properties and Partial Dispositions

• Additional info: These topics require further reading, but generally involve special rules for calculating ACB when multiple identical assets are held or only part of an asset is disposed.

Capital Gains Reserve

When proceeds from the sale of a capital asset are not fully received in the year of disposal, a reserve can be claimed for up to five years.

• Calculation:

• Prior year reserve must be added back each year, and a new reserve may be claimed if desired.

Special Rules

Bad Debts

• If a receivable from the sale of a capital asset is written off, it is treated as a capital loss (ITA 50(1)).

• This results in the same tax treatment as adjusting the original proceeds to reflect actual proceeds received.

Warranties

• Future costs to honor warranties on capital asset sales are treated as capital losses (ITA 42).

• Full proceeds, including warranty premium, are used to determine the capital gain.

• Since only 50% of the gain is taxable, only 50% of the warranty costs are allowable as a loss.

Special Assets

Options (Issuer and Purchaser)

• Issuer: Proceeds from sale of options are treated as capital gains. If options expire, no further tax impact. If exercised, proceeds are added to share proceeds, and prior gain on options is removed from earlier tax returns to avoid double taxation.

• Purchaser: At purchase, ACB equals purchase price. If options expire, a capital loss occurs. If exercised, option price is added to share cost; no gain or loss on options.

Principal Residences

• Defined as a property "ordinarily inhabited in the year." Only one per family per year.

• If more than one, family must choose which property to designate for exemption.

• If CCA (Capital Cost Allowance) is claimed on a home office, that portion is not eligible for exemption.

• Principal Residence Gain Reduction Formula (ITA 40(2)(b)):

Where: A = Total Capital Gain B = 1 + Number of years designated C = Number of years owned

• Partial years count as full years. The formula allows for exemption when two properties are owned in the same year.

• Example: The Smiths own a townhouse (2018–2021, gain $40,000) and a house (2021–2025, gain $100,000). Using the formula, both gains can be fully exempted by designating appropriate years.

Principal Residences - Rentals

• If a principal residence becomes a rental or business property, it is normally deemed disposed of at fair market value.

• Taxpayers can elect to defer the change in use for up to 4 years (ITA 45(2)), provided no CCA is claimed.

• If a rental property becomes a principal residence, a similar election is available (ITA 45(3)).

• If only part of the residence changes use (e.g., home office), no change is deemed unless structural changes occur.

Personal Use Property

• Capital losses on personal property are disallowed unless the property is listed personal property.

• Capital gains are taxed, but a minimum of $1,000 is used for both proceeds and ACB (ITA 46(1)), so small gains are not taxed.

Listed Personal Property

• Defined as works of art, jewellery, rare books, stamps, coins (ITA 54).

• Capital losses on listed personal property can be used against gains from such property in the current year, 3 years prior, or 7 years after. The $1,000 minimum rule applies.

Real Estate Rules

Terminal Loss with Capital Gain

• Buildings and land are usually sold together. Capital gains on land are 50% taxable; terminal losses on buildings are 100% deductible.

• Taxpayers may allocate proceeds to minimize taxable income, resulting in a capital gain on land and a terminal loss on the building.

• Proceeds must be reallocated so only a capital gain on land or a terminal loss on the building remains (ITA 13(21.1)(a)).

Replacement Property

• Businesses may defer capital gains and recapture when replacing assets (ITA 44(1), ITA 13(4)).

• Voluntary Disposition: Replacement property must be for similar use in the same business; deferral is only available for real property and must be replaced within one year of taxation year end (ITA 44(5)).

• Involuntary Disposition: Applies when property is lost, stolen, destroyed, expropriated, or seized. Replacement property must be for similar use; deferral is available for most depreciable property, but mainly applies to land/buildings. Replacement must occur within two years of taxation year end.

Deemed Dispositions

• Assets are deemed disposed of upon change in use, departure from Canada, or death.

• Proceeds are deemed to be fair market value unless transferred to a spouse (automatic rollover uses tax values).

Change in Use

• When property use changes (e.g., business to personal), deemed disposition and reacquisition at fair market value occurs.

• Capital gain, recapture, or terminal loss is determined based on deemed proceeds.

• If personal property becomes business property, addition to CCA class depends on whether a capital gain occurred.

• If no gain, addition to CCA is fair market value (half-year rule applies). If gain, addition equals original ACB plus 50% of the capital gain (ITA 13(7)(b)).

• ACB to the business equals fair market value on the date of transfer.

Change in Use - Automobiles

• Business/employment use percentage may vary yearly. Instead of annual capital gain calculations, vehicle expenses and CCA are prorated for business/employment use.

Departures from Canada

• Generally, all assets are deemed sold at fair market value (ITA 128.1(4)(b)).

• Exceptions: Canadian real property, Canadian business property, excluded rights and interests (e.g., RPP, RRSP).

• $1,000 limit on personal property applies.

Additional info: These notes are based on Canadian tax law and accounting standards, with references to the Income Tax Act (ITA). Students should consult assigned readings for details on identical properties and partial dispositions.