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How Investing Taxes Work (Part 1 – Capital Gains)

With tax season right around the corner, I figure this is a good time to start posting some tax related articles. Are you curious about how investing taxes are calculated? Specifically, capital gains tax? If so, you have come to right blog! I am by no means a tax expert but I do have enough knowledge to give general guidelines on how you can figure out your own investment taxation. Note that these tax guidelines described in this post are for Canada only. On top of that, you should consult a tax professional before applying anything you read on my blog and the web in general. :)

Lets start with RRSP’s. As you probably know, RRSP contributions and investment growth are taxable only upon withdrawal. At that point, the withdrawals are taxed as income at your marginal tax rate at the time. That’s the strategy behind RRSP’s: contribute, let it grow tax free, and withdraw when you are in a lower tax bracket (hopefully).

Now on to Non-registered accounts. There are 3 types of taxes that you need to consider.

  1. Capital Gains tax (preferred)
  2. Dividend Tax (preferred)
  3. Interest tax (keep in RRSP)

Capital Gains (CG) Tax

When you profit from selling a stock in a non-registered account, you will be subject to capital gains (CG) tax. What are capital gains? Capital gain is the difference between the selling price and buying price of a stock less the commission. For example, if you sold a stock for $1000 (inc selling fee) and paid $800 (inc buying fee), you would have a capital gains of $200. Capital gains tax are subject to a 50% inclusion rate. This means that 50% of your profit will be included as income. So in our above example, $100 would be added to your income and taxed at your marginal rate. Or another way to look at it is that any profits from a stock sale in a non-reg account are taxed at HALF your marginal rate.

The 50% inclusion rate is a reason why most financial gurus suggest that you keep investments for the purposes of capital appreciation/gain outside of your RRSP. If you keep your capital appreciation/gain assts inside an RRSP, you will be taxed on 100% of the gain because all income withdrawn from an RRSP is taxed at your marginal rate.

Another advantage of keeping your capital appreciating stocks outside of an RRSP is because you can claim your losses against your gains to reduce your taxes payable. Whereas within an RRSP, losses cannot be claimed. For example, if in 2006 you sold stock for a $4000 non-reg portfolio profit and $1000 in losses, your total profit is now $3000. To figure out your taxes payable, it would be: $3000 x 0.50 = $1500. This $1500 would be added to your taxable income for that year and taxed at your marginal rate.

This is why you’ll read some tax strategies to sell your losing stocks at the end of the year. The losing amount will be deducted from your total winning amount and reduce your overall taxes. What if you have a loser for the year, but you believe it’s a long term winner? You’re probably thinking to sell it before the end of the year and purchase it again. Not so fast, you have to make sure you don’t violate the superficial loss rule.

What is the superficial loss rule?

According to: http://www.cabusinessadvisor.com/Tax/TaxTraps/SuperFL.htm

This rule applies where a person or affiliated person acquires or had the right to acquire the same or identical property within 30 days after the disposition or 30 days before the disposition of the property in question. The disposition could have been made to anyone. In these cases, the loss on the disposition is denied and the amount of the loss is added to the cost of the substituted property.

In layman’s terms, it simply means that if you sell a stock at a loss, you can’t repurchase the shares back again within 30 days and claim the loss against your gains. However, if you do repurchase the same shares back within 30 days and you profit from it in the future, you can deduct the initial loss against your gain of THAT stock.

For example:

  • Purchase 10 ABC stock for a total cost of $1000
  • Sell 10 ABC stock for: $800
  • Loss: $200
  • Repurchase 10 ABC stock within 30 days for: $850
  • Sell 10 ABC stock in the future for $1200:
  • Profit: $1200-$850-200(initial loss) = $150
  • Taxable Amount: $75 ($150 *50%)

As a side note, you should consider the superficial loss rule if you are attempting the Smith Manoeuvre (SM). The SM suggests to sell your non-reg stock to pay down your house, then REPURCHASE the stocks. If you sell stock at a loss, you should wait 30 days before repurchasing. Otherwise, the loss will be omitted.

In summary:

  • Capital gains are taxed at 50% of your marginal rate (efficient).
  • Keep your capital appreciating stocks/mutual funds outside of your RRSP.
  • If you trade often, sell your losers at the end of the year to reduce your profits for the year.
  • Take heed of the superficial loss rule.

Taxes can be boring but they are an essential component to financial planning. In the next article (Part 2), we’ll discuss the other 2 types of investment taxes, dividend and interest income tax.

If you have anything to add to this article, please post them in the comments.

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 123 comments… add one }

  • trollmonger June 6, 2012, 3:19 pm

    My wife owns a house that is not her primary residence. Accordingly, she will pay capital gains taxes when she sells.

    But what will be her tax rate? Is the capital gain part of her income? For example,

    Purchase price: $200K
    Sale price: $600K
    Capital gain is $400K of which $200K is taxable.
    If her employment income is $40K, is her tax rate based on 40K or 240K for that year?

    • FrugalTrader FrugalTrader June 6, 2012, 9:17 pm

      @trollmonger, best bet would be to input your tax scenario into a tax calc, like taxtips.ca, and see what kind of tax owning there will be. As well, did you wife life in the home at all? If so, then the adjusted cost base will be different than her purchase price.

  • trollmonger June 7, 2012, 12:52 pm

    Thanks FT,

    Taxtips answered my question. It wasn’t the answer I was hoping for though. That’s a lot of taxes!

    She did live in the house before we married. Her parents live there still. I didn’t think to have the house appraised when she moved out but I’m sure we’ll find a way to estimate the value at the time. We just need CRA to agree.

  • Dan September 18, 2012, 12:14 pm

    Hi FT,
    I just found your blog and it is an awesome blog seems I am pretty much on the same boat as you are.

    A quick question about Capital Gain. I have a decent size investment managed by a private investment firm (a division of a big bank) on a non registered account which currently have about $50K capital gain should I liquidate the account. The investment is invested in money market, stocks and bonds in Canada and US.

    I recently decided to learn more about investing and have a self-directed account for RSP and TFSA on a brokerage account of the same bank. My goal this year is to take over my non registered investment account from the private investment firm and self manage it. Hence, avoid the hefty fee that they charge every month.

    My question is: when I am ready to take over my non registered investment account, should I liquidate it and realized the $50K capital gains? or will I be better off to actually transferred the investment to my discount brokerage without liquidating the assets? i.e. carrying the original costs of the investments to the discount brokerage (I understand from my broker that this is possible since both my discount brokerage account and non registered investment are divisions of the same big bank).

    FYI: this year my marginal tax will be very low since I took some time off and have not earn much income (my expected income outside any capital gain will be in the $20K-$30K neighborhood).

    Thanks FT,

  • FrugalTrader FrugalTrader September 18, 2012, 7:37 pm

    @Dan, thanks for the kind feedback. Do you still like the investments that are held in the private account? If so, then you should consider simply transferring in-kind to another non-reg account and managing them from there. I believe brokerages will charge about $150 to transfer stocks/bonds over to a new account.

    Does this help?

  • Dan September 18, 2012, 11:11 pm

    Thanks FT,

    I do like some of the investments but will definitely get rid some of it.

    Consideration to liquidate or not was more for the tax purposes since this year my marginal tax will be at lower rate. I thought it would be a good idea to realize the gain. But I am not sure if that will actually matter.

    Thank you.

  • FrugalTrader FrugalTrader September 19, 2012, 9:46 am

    @Dan, it’s never a bad thing to pay less tax! However, you also need to look at the big picture and if you would sell the investment at all if it weren’t for the tax consequences.

  • Mike February 10, 2013, 11:17 am

    Let’s assume that I buy 100 shares of the same stock each month for 25 years, and plan to sell them for retirement income as needed. It’s safe to assume that the price per share will change month by month, or year by year.

    In 25 years from now when I start selling portions of my portfolio for retirement income, how do I know what price I paid for the portion of shares I’m selling?


  • Danielle February 23, 2013, 12:43 am

    Mike, the adjusted cost base of the shares is affected each time you buy more shares. If you continue to buy shares and the price per share goes down, then this will decrease your ACB. And subsequently affect any gains you may have. When you eventually sell, the gains and losses are calculated using the adjusted cost base. Think of all the shares going into a cost “pool” in which the cost is adjusted every time you buy more shares of the same company.

    When you do sell the shares the taxes you pay will be based on your marginal tax rate. Any capital gains will be included in your income for that year (50%). The other 50% of the gain is not taxable.

  • gogernator December 10, 2013, 2:18 pm

    HI Folks, I have a quick question – I have a capital loss that I’m carrying of around 11k, I’m going to sell some stock options I have creating a capital gain, is the loss applied against the gain only, or on total amount of the share options excersied? An example would be:

    I excercise 40K in share options and recieve 30K in net cash (50% of 40K is 20K taxed at 50% = 10K in tax). Would my capital loss of 11K be applied against the 20K in capital gain gross ie my 20K becomes 10K and I now only owe 5K in capital gains tax?

  • Wayne March 10, 2015, 11:38 pm

    I’m in something similar to the Smith Manoeuvre. I have a HeLOC and I pay into Segregated funds every month and the interest only payments. As my funds build up in value, eventually, I can cash out and pay off my home. My question is… How do I know what my Tax Hit will be before I cash out? someone said to cash out $30,000 for the next 5 years to minimize Capital Gains Tax? Can you tell me how I would figure out the Tax Hit? I guess I go back to the holder of my Seg Funds and ask them? Both my fund mgr and the holder of the funds said my taxes would be approx. $6,000 on withdrawal of $30K…. when I got my T-3, the capital gains was like $14K! what gives? How do I find out what my taxes on capital gains will be? I’d like to cash out totally but I’m afraid of the Tax Hit.

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