Realize that taking into account capital gains in Canada on investments can lead you to save more on taxes—that’s because it’s a tax-advantaged form of income worth targeting

Capital gains in Canada on investments is the tax paid when an individual sells an asset outside of an RRSP, RRIF, TFSA or other registered account, and profits from the sale. 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 tax on capital gains on a portion of your profit. The “capital gains inclusion rate” determines the size of this portion (more on that below).

In Canada, tax on capital gains is at a lower rate than tax on interest, or even dividends for that matter. You can take advantage of that by structuring your investments so that more of your income is in the form of capital gains.

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About 20 years ago, the Canadian government cut the capital gains inclusion rate from 75% to 66.6% and, within a few months, to 50%. This effectively cuts tax on capital gains, and had the overall effect of lowering the overall rate you pay on capital gains to roughly one-half of what you would pay on ordinary income or interest.

One of the main advantages capital gains have over other forms of investment income is that you control when you pay tax on capital gains—you don’t realize capital gains until you sell. This amounts to a very simple and highly effective way of deferring tax—and it’s perfectly legal.

Know the ins and outs of calculating capital gains in Canada on investments to improve your long-term results

To calculate your total capital gains in Canada on investments, subtract the adjusted cost base of the shares you sold from the total proceeds of the sale. The adjusted cost base of the shares is equal to the cost of the shares when you bought them plus any costs associated with owning them such as brokerage commissions.

For example, say you bought 1,000 shares of Canadian National Railway at $10 per share years ago. When you made the purchase, you paid $50 in brokerage commissions. When the stock reaches $60 per share, you decide to sell. Your proceeds from the sale are $59,950 ($60 per share multiplied by 1,000 shares minus $50 in brokerage commissions) and your adjusted cost base (the cost of purchase) is $10,050 ($10 per share multiplied by 1,000 shares, plus the $50 in commissions).

If you’ve bought shares of the same company more than once, the adjusted cost base you need to calculate your Canadian capital gains tax is equal to the average cost of your shares. You can determine the average cost by dividing the total cost of all the shares you’ve purchased by the total number of shares you hold.

Investors who know these three strategies for capital gains in Canada on investments can boost their profits

As Canadian capital gains tax is lower than the tax on interest and 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. (Note, though, that there is no problem with holding dividend-paying stocks in an RRSP if you want to, or that’s all you own.)
• 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 consider holding mutual funds in an RRSP and common stocks outside, if that suits your portfolio composition. 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.

Be aware that the “superficial loss rule” regarding capital gains in Canada on investments can influence your earnings

If you are considering making use of tax-loss selling to minimize capital gains in Canada, you should also be aware of the “superficial loss rule.” This rule states that if an investor, their spouse or a company they control, buys back a stock or mutual fund within 30 days of selling it, then they are not permitted to claim the capital loss for tax purposes. Failing to obey the 30-day rule will result in the capital loss being disallowed.

Use our three-part Successful Investor approach to profit from your investments

1. Invest mainly in well-established, dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Should capital gains continue to be taxed at a lower rate in Canada than interest or dividend income?