A Canadian capital gains tax return is filed when an individual sells a stock outside of an RRSP or RRIF and profits from the sale

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”—now set at 50%—determines the size of this portion.

A Canadian capital gains tax return comes from gains that are taxed at a lower rate than interest. You can take advantage of that by structuring your investments so that more of your income is in the form of capital gains.

Three capital-gains strategies

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

1. 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.
2. 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.
3. Regarding mutual funds outside an RRSP, the main consideration is that mutual funds can 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 lower tax rates 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.

How to calculate your Canadian capital gains tax return

When you sell any stock outside of an RRSP or RRIF, you must pay capital gains tax if you’ve made a profit on the sale.

To calculate your total capital gain on a share you sold during the previous tax year, 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 plus any costs associated with owning them, such as brokerage commissions.

If you’ve bought shares of the same company more than once, the adjusted cost base you need to calculate your capital gains tax is equal to the average cost of each share. 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.

Choose when to pay tax on capital gains

One of the main advantages capital gains have over other forms of investment income is that you control when you pay capital-gains tax. This amounts to a very simple and highly effective way of deferring tax—and it’s perfectly legal.

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, 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.

This can have a significant impact on your long-term returns.

Have you calculated your Canadian capital gains tax return using our advice? Please share your experience with us in the comments.