Looking to take full advantage of your capital gains deduction? You’ve come to the right place for the necessary information

Looking for a capital gains deduction? You have to pay capital gains tax on profit you make from the sale of an asset. An asset can be a security, such as a stock or a bond, or a fixed asset, such as land, buildings, equipment or other possessions. However, you only pay the tax on a portion of your profit. The “capital gains inclusion rate” determines the size of this portion.

The capital gains inclusion rate is 50%. This cuts taxes on capital gains, and has the effect of lowering the overall rate you pay on capital gains to one-half of what you would pay on ordinary income or interest.

Here’s how tax on capital gains compares to other forms of investment income:

• Capital gains: If you buy stock for $2,000 and then sell that stock for $4,000, you have a $2,000 capital gain (not including brokerage commissions). You would pay tax on just 50% of the capital gain amount, or $1,000. This means that if you earn $2,000 in capital gains, and you are in the highest tax bracket in, say, Ontario (49.53%), you will pay $495.30 in capital gains tax on the $2,000 in gains.
• Interest: Unlike capital gains, interest income is fully taxable. In the 46.41% tax bracket, you’d pay $990.60 in taxes on $2,000 in interest income.
• Dividends: The dividend tax credit applies to all dividend income from Canadian corporations. As a result, you would pay tax at a rate of 29.52%, or $590.40 on $2,000 in Canadian dividend income.

Strategies for maximizing your capital gains deduction

As Canadian capital gains tax is lower than the tax on interest and on dividend income, capital gains is a very tax-advantaged form of income. However, since most investors have income of all three types, here are three strategies for structuring investment portfolios to minimize the tax burden.

• It is usually best to hold any common shares outside of an RRSP (as dividend income and capital gains taxes are taxed lower than interest income), and interest-paying investments in an RRSP. If you only hold common shares, they are okay to hold in an RRSP.
• More speculative investments are best held outside of an RRSP. If investors hold them in an RRSP and they drop, investors not only lose money, but they can’t use the losses to offset any taxable gains from other investments.
• Regarding mutual funds outside an RRSP, the main consideration is that mutual funds make annual capital gains distributions even if investors continue to hold the fund units. Investors then pay Canadian capital gains tax on half of any realized capital gains. So you are best to hold mutual funds in an RRSP and common stocks outside. You won’t realize capital gains on common stocks until you sell.

A properly structured investment portfolio can let you take advantage of the low tax rate on capital gains and dividend income while sheltering your higher-taxed interest income in your RRSP. If you make dividends or capital gains in an RRSP, you gain the tax shelter of the RRSP, but when you withdraw the funds from your RRSP they are taxed at the same rate as interest income. This means you would lose out on the lower tax rates offered.

Tax loss selling and your capital gains deduction

You pay capital gains tax on a stock only when you sell, or “realize” the increase in the value of the stock over and above what you paid for it. In contrast, interest and dividend income are taxed in the year in which they are earned. As an added bonus with capital gains, if you sell after you retire, you may be in a lower tax bracket than you are when you are earlier in your investing career.

In any event, the longer you hold onto a profitable stock and put off paying capital gains tax, the longer all of your money works for you. If you hang onto the stock, you keep the full amount working for you until you choose to sell. That holds out the potential for even further gains, and the possibility of paying less tax on your added capital gains if you sell after you retire, when you may be in a lower tax bracket.

It’s always a good time to sell bad stocks, or stocks that are wrong for your portfolio. But note that in the final couple of months of the year, some investors dump stocks without thinking, just to cut their taxes. In some cases, they simply want to sell and be done with it. If you’re not in a hurry, you might want to sell before or after that time of year.

Have you ever received a capital gains deduction? Please share your story with us in the comments.