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How Investing Taxes Work (Part 1 - Capital Gains)

Written by FrugalTrader on Jan 22, 2007 filed under Tax Minimization

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? 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.

Capital Gains tax (preferred)
Dividend Tax (preferred)
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you keep your capital appreciation/gain assts inside an RRSP, you will be taxed on 100% of the gain because all income withdrawn from an RRSP is taxed at your marginal rate.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.

59 Comments, Comment or Ping

1. Ryan

Thanks for the explanation. I have never fully understood how capital gains worked until just now. Look forward to the dividend and interest income tax entries :)

Jan 22nd, 2007 @ 3:14 pm
2. Steve

“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.”

Are you suggesting that people should only use RRSP room for interest paying bonds, and securities that are held for their ability to pay dividends? It seems to limit the amount of RRSP room one should use since the majority of people’s portfolios are usually in equities that they hope to appreciate in value. What is your approach to the distribution of asset classes between your registered and non-registered accounts?

Jan 22nd, 2007 @ 5:20 pm
3. FrugalTrader

Hi Steve,

According to the literature that i’ve read from financial guru’s/advisors, it is recommended that you keep all dividends and capital gains OUTSIDE of your registered account. The reason being is that if you keep capital appreciating and dividend paying assets inside an RRSP, you miss out on the tax credits AND you end up paying 100% tax on your gains upon withdrawal.

When you retire, would you prefer to have a HUGE RRSP? Or a HUGE non-registered portfolio? I would pick the non-reg portfolio due to the tax advantages.

Now mind you, I still keep some dividend paying stocks within my RRSP b/c it’s something to spend my RRSP money on. Another perk is that I don’t need to keep track of my adjusted cost base on re invested dividends if I do decide to sell. But for efficiency sake, with the new enhanced dividend tax credit, I believe the studies show that dividends outside an RRSP is more efficient. However, you’ll have to do your own due diligence to confirm.

One more thing, only Canadian public companies are eligible for the enhanced dividend tax credit (as you’ll see in part 2). Foreign dividends are 100% taxed, so they belong within an RRSP.

Hope this answers your question.

FT

Jan 22nd, 2007 @ 5:41 pm
4. Steve

Thanks for the reply,

I see what you are saying. Perhaps we can say that “in general” RRSPs are a good place for interest paying bonds and foreign securities. And non-registered accounts are better for Canadian securities.

But how about appreciation of foreign securities? Are they taxed at 100% or 50%? If capital gains on foreign investments are also taxed at 50% it may still make sense to keep them in a non-registered account as well.

Steve

Jan 22nd, 2007 @ 6:05 pm
5. FrugalTrader

Hey Steve,
Yes, interest and foreign income should definitely be kept in registered accounts due to high taxation.

I’ve only invested as far as the United States. Any capital appreciation realized in the US market are also subject to capital gains tax (50%).

It’s only a matter of time before the govt reduces the capital gains inclusion rate and increases the dividend tax credit again. When that happens, people are going to wish that they had a bigger non-reg portfolio. Of course, that is just my opinion. :)

FT

Jan 22nd, 2007 @ 10:25 pm
6. Canadian Money Blogs Reviewer

excellent article FT! thanks for the related comments on my site

Jan 23rd, 2007 @ 7:23 am
8. Dom

FT,

Thanks for this great article. Could you explain how profits from stock options are taxed? Is there a different tax-treatment-wise for stock options granted by employer from options purchased on the open market? I am concerned that the latter may be taxed as income as opposed to capital gain since they tend to be short-term in nature.

Jan 24th, 2007 @ 1:12 am
9. FrugalTrader

Hey Dom,

To be completely honest with you, I’m not 100% sure how EMPLOYEE stock options are taxed. Here is an article that includes an example that may help you:
http://www.grantthornton.ca/taxtips/taxtips_template.asp?TipID=92

FT

Jan 24th, 2007 @ 6:37 am
11. Ken

Was wondering when one becomes a day trader or just an investor, when it comes to claiming capital gains or income. I have moved from a few trades a year to more than 100 and someone mentioned to me that I had to report it as income,instead of capital gains.

Apr 14th, 2007 @ 1:58 pm
12. FrugalTrader

Hi Ken: The line between trader/investor is grey. According to tax experts, it depends on your “intent” of your stock trading. I think the CRA also looks @ your personal situation. For example, if you already have a full time job, then it’s more than likely that you won’t be considered a trader.

Also note that if you are deemed a trader, your trading will be considered a business where you’ll be able to deduct 100% of your losses and your trading expenses (home office etc).

Hope this helps,
FT

Apr 14th, 2007 @ 6:45 pm
19. chris

Hi!This is my first entry.I have in the process of purchasing a condo in Panama.Our principle residence will remain in Canada so I was wondering what capital gains would be in place if I sold this condo and if I should register it under a business name.

Oct 4th, 2007 @ 10:14 am
20. Michael

Thanks very much for the clear explanation.
I wonder if you could answer me three questions:

1, do i need to report the realized short-term profit (but still kept in the non-reg account) even though the amount is NOT cashed out?
for example, in year 2005, an initial investment is $1000, and the short-term realized profit is $200, no loss. However, i did not cash out any. Am i required to report the $200 profit?

2, is that true to say the taxes will apply only if i cash out any money from the non-reg account??

3, if one day down the road, i closed my non-reg account and cash out everything, will the taxes only apply towards the NET profit or entire cashed out amount?

thanks very much

Oct 23rd, 2007 @ 7:44 pm
21. Bryce

If you sold the security/stock/etf then you did “cash out” it doesn’t matter if the money is still just sitting in the account.

Oct 23rd, 2007 @ 9:03 pm
22. FrugalTrader

Hey Michael,

1. Yes, whenever you sell in your non-reg account, you need to report it. Selling is the same as cashing out.

2. No, this is not true.

3. Capital gains taxes apply to your profits.

Oct 23rd, 2007 @ 9:04 pm
23. Michael

thanks very much for the reply.
i wonder what i should do if i did not report previous years’ capital gains due to the misinformation. Will there a penalty? what shall i do?

thanks very much

Oct 24th, 2007 @ 1:23 am
24. FrugalTrader

Michael, you’ll have to consult with an accountant about previous years.

Oct 24th, 2007 @ 11:12 am
26. Paul Victor

I have built a business (Canadian Corp) and wish to sell. I will have huge capital gains even if I sell shares and not assets. Very good Cash Flow business, so perfect for another company to amalgomate. Still Capital TAx will be huge. I have 2 children and wife. I am thinkihg about gifting to children. Apon my death my younger wife will get my asset roll over tax free I think. I also own another small company (Canadian Corporate) also, and would like to buy or invest in that to keep down the Capital Tax. I have worked my butt off for 38 years and now hate to pay so much after a life time of huge tax each year.(and corporate tax too each year)
Any comments?

Nov 18th, 2007 @ 7:33 pm
28. Ken Thomas

Hi FT,
I am an american citizen and have invested in the Canadian real estate market. I am selling my “assignment” on a condo currently being constructed. As a foreign invester, how would I be tax? The same as a canadian citizen? I greatly appreciate your inpu,
Ken Thomas
Palm Springs, California US

Dec 7th, 2007 @ 12:50 am
30. Jared

Does anyone know how selling covered call options are taxed? It is just considered capital gains, or can you just use the value to lower the adjsuted cost base of the stock that you have and pay the tax when you sell the actual stock?

Jan 27th, 2008 @ 8:16 pm
31. Dom

Great question, Jared.

I also wonder about this question, and I would like to know if using covered calls would nullify the tax benefits of a “Smith Maneouvre” strategy (i.e. if i borrow money to invest in a stock AND writing covered calls on them, is my debt’s interest still tax deductible?)

Jan 27th, 2008 @ 11:10 pm
32. chris

My wife and I are in the process of purchasing property in Panama.We plan to live in Canada for 6 MTHS and there for 6 MTHS.How would capital gains work if we sold that property or bought another as an investment and sold it?Should we register it in our names or form a company for this purchase.Cheers! Hope someone can help me!Chris

Jan 28th, 2008 @ 1:53 pm
33. fred fownes

In the year 2007 i sold “ABC” stocks 3 times. I have been buying this stock for 6 or 7 years. How does one know what profit (gain) was made ? Saying it is the difference between what you paid for it and what you sold it for is AN OVERSIMPLIFICATION ?? I can’t be the only investor who has this problem
Thanks,
F Fownes

Feb 26th, 2008 @ 1:01 pm
34. FrugalTrader

Fred, you’ll need to go back into your records and calculate your total purchase Adjusted Cost Base (ACB) for the stock. From there, you’ll be able to determine the profit from your sale prices.

Feb 26th, 2008 @ 1:11 pm
35. tomw

You can do the capital gains tracking in a stock tracker or capital gains software tracker on your computer. “Stox” on Mac OS X is the best option, there are many other excellent software applications for Windows PC’s that track stocks (just enter in every transaction) and you will get a running total of your capital gains and losses.
I’m sure the PC folks here can mention their favourite Capital gains stock tracking software.
(you still have to manually enter in every buy and sell transaction)

Mar 7th, 2008 @ 5:47 pm
36. Jason Mathew

Hi !! This is a very good and informative post about taxes in canada, I liked it, but can you provide information on taxes in UK. It would be quiet a help.
thanks
Jason

Mar 25th, 2008 @ 4:48 am
37. Nathan

I am considering buying property in the US, being that prices are quite attractive, and was wondering if anyone is familiar with taxation associated with Canadians buying property in the US. If I do decide to buy property now and sell when the property has appreciated again, how and where will I have to pay capital gains taxes? Would it be more beneficial to pay in the US or in Canada? I heard that you just pay taxes in one country as per NAFTA…

Mar 26th, 2008 @ 3:08 pm
38. XGW

Hi,

How to calculate the capital gain/loss if I sell a portion of the stock ?

Say, purchased 10 ABC stocks for a total cost of $1000
and sold 5 ABC stocks for $600, capital gain would be $100 ?

I would appreciate your reply.

XGW

Apr 2nd, 2008 @ 10:24 pm
39. FrugalTrader

XGW, it depends on your adjusted cost base on the stock. In your case, your 10 stocks had a cost base of $100 each. Since you sold 5 of those shares at a cost base of $500, your capital gain would be $100 as you indicated. I have an article on ACB coming soon.

Apr 2nd, 2008 @ 11:04 pm
40. Ann

If I purchase $1000 in stocks and at the end of the year they are worth $1200 but I don’t cash them out, I keep the stock. Do I have to claim the $200 in my taxes as an income for that year and pay taxes on it. Or do I only report it on my taxes when I actually sell the stock down the road and have still made a profit?

Apr 4th, 2008 @ 1:05 pm
41. FrugalTrader

Ann, you only report capital gains when you sell.

Apr 4th, 2008 @ 1:11 pm
42. Dawn

I’ve been investing since last July - I have both capital gains and losses in my non-registered account for 2007. I had about 30 trades. I was unemployed for the past 5 years, so zero income for 2007.

I have a few questions, hope someone can help me with this - its all very confusing to me:

1) Can I claim my trading expense cost for buying and selling those stocks for 2007.
2) I lost money converting Cdn$ to US$ to buy stocks and also converting it back to Cdn$ - can I claim this loss?
3) Where on the 2007 tax form do I put my capital gain
its not employment income? What line #?
4) where do I find out my tax bracket for the capital gain? any website?
5) What would be the amount I put as capital gain on the Tax Form - is it the total before losses and expenses or after?

For e.g lets say my capital gain was 20,000 and my losses were 8,000 = 12,000

My trading expenses, let say = 1,000
My currency conversion loss = 1,000

Will it be 12,000 - 2,000 = 10,000 x .50% = 5,000 I would put on the taxation form as capital gain?

6) Does my partner put my capital gain on his return as my income even though I wasn’t employed?

I would really appreciate your help with this - I dont have an accountant and the end of April is fast approaching. Thanks in advance.

Apr 7th, 2008 @ 10:57 pm
43. FrugalTrader
Dawn, your questions would require someone who is qualified to answer. A quick a dirty way to get an answer is to fill out your tax information via an online program and they will step you through what information to put where. Both ufile and quick tax are popular.

However, I can give you some pointers (note that i’m not a tax pro).
- trading costs can be claimed.
- forex losses can be claimed.
- to find your tax bracket, you add up your capital gain and multiply by 50%. That number will be added to your income for that year.
- with regards to “who” claims the gain, it needs to be consistent to previous years. another thought is that if you are unemployed, the money needs to come from “somewhere”. I would think that your husband would need to claim the gains if he is the one funding the investment account. Not unless he loaned you the money. This issue should really be answered by a tax pro.
Apr 7th, 2008 @ 11:08 pm
44. Dawn

Frugaltrader,

Thanks very much for your response, and for the online and pointer information.

p.s I have been using my savings,line of credit and existing stocks to fund my trading activities. I’ll claim the interest incurred on my line of credit even though it wasn’t designated for trading.

Thanks again.

Apr 9th, 2008 @ 1:21 pm
45. Dawn

FrugalTrader,

Thanks very much for your response and for the information on the online programs and pointers.

p.s I used my savings, existing stocks and line of credit to fund my trading actitivies - I’m planning on claiming the interest incurred on the line of credit for the year.

Thanks again

Apr 9th, 2008 @ 1:32 pm
46. James

One thing to consider when investing in your RRSP. As you say capital gains are taxed at 100% of your marginal rate inside your RRSP but if I invested in lets say microsoft 25 years ago my $5000 investment is now worth millions of $ while my interest bearing long bond is worth maybe $13000. I can pay the tax and still have nearly a 1000 times more money than I would if I invested in the long bond. I know MSFT is not exactly typical of the average equity return but I hope you get my point.

Jim

Apr 12th, 2008 @ 1:40 pm
47. FrugalTrader

What if you invested in MSFT OUTSIDE your RRSP? Then you would get all the appreciation, but only get taxed 50% on the profits instead of 100%.

Apr 12th, 2008 @ 9:12 pm
48. James

I would probably invest in MSFT outside of my RRSP and inside my RRSP.However since we are at the end of a grand super cycle degree advance in stock prices (yes im an elliott wave guy) I wouldnt being investing too heavily in equities for the long term. BTW we are going to have one more counter trend reversal which should take us us to 2550 on the NASDAQ before the final move down.

James

Apr 14th, 2008 @ 1:02 am
50. TrendFollowing

===
My wife and I are in the process of purchasing property in Panama.We plan to live in Canada for 6 MTHS and there for 6 MTHS.How would capital gains work if we sold that property or bought another as an investment and sold it?Should we register it in our names or form a company for this purchase.Cheers! Hope someone can help me!Chris
===

If it is on a company name you only have to pay taxes when you take the money out from your company but your company may have to pay taxes too depending where it will by registered (Canada or Panama).

Apr 26th, 2008 @ 2:53 pm
51. Terrie

I know someone who has plenty of stocks, but plenty of debt, too. Is there any way they can use some of the stocks to pay down some debt without incurring lots of capital gains? The only think I can think of (I am definitely not too financial savvy) is to transfer some of the stock into RRSPs (max out their contribution room). Would they get a big tax refund they can then use to pay down some debt? Any advice?

Terrie

Jul 29th, 2008 @ 2:58 am
52. FrugalTrader

Terrie,The problem with transferring your non-reg stock to your RRSP is that they are deemed sold at that price, which means that you will be faced with a capital gains tax providing that there is a profit. In addition, if there is a LOSS during that time, the loss cannot be claimed against any gains.

I would suggest that your friend stop all portfolio contributions and put all excess cash flow, savings and dividends received towards debt. If the interest on his debt is high, like credit card debt, it may be worth his while to take the tax hit from selling stock and paying down the bill.

FT

Jul 29th, 2008 @ 6:52 am
53. Denys

What a nice site is this!
I was investing in Mutual Funds all the way and the information here (about CG, Dividends and online brokers) gives me the idea that the ONLY proper way to invest money OUTSIDE of RRSP would be in Stocks and ETFs.
I have some questions here:
1. Am I right that with Mutual Funds there are no tax breaks? Like if I invested $1000 and then received $1200 from it, then I pay a tax on $200 while if I do same thing via ETF, I pay it only from half of that amount (being $100)?
2. What about fees paid to broker companies ($5-$10 per transaction)? Is it tax deductible as investment expenses?
3. If my wife has no other income and some investments are on her name - she does not pay any taxes on investment income (when it’s below $9k p.a.), however this reduces my tax credit and effectively increases my taxes for something like 10-20% of the amount. Is there any benefit in this case with capital gains vs. interest income?

Thank you very much, FT!

Jul 29th, 2008 @ 9:39 pm
54. FrugalTrader

Hi Denys, thanks for the kind feedback.

1. capital gains with mutual funds are treated the same as capital gains with ETF’s. So in your example, tax would be paid on $100 at your marginal tax rate (mtr).

2. Commissions on each transaction are used to increase the adjusted cost base.

3. I would need to run the numbers, but something to consider is that only half the of the capital gains is added to income thus much more efficient than interest income.

Hope this helps!
FT

Jul 29th, 2008 @ 10:55 pm
55. Chuck

Denys:

For Question #3 You might also want at having your wife invest in Dividend paying stocks. As long as the company is Canadian and its an “eligable” dividend (CRA’s rules) there are tax advantages. A person could earn about $25k in eligable dividend income and not pay any taxes on it.

You’d also have the potential that the stocks could appreciate.

Jul 30th, 2008 @ 12:26 am
56. Ken

I have a Corporation which owns a Rental Real Property.The Corporation does not do any other business(it is a shell company).This property is now sold (to close in sept this year) for a potential profit of approx 40K.
This I believe will classify as Capital gains. My question is
a) Is all of this taxable or 50% is taxable
b) How to minimise taxes arising from this sale

thanks
Ken

Aug 3rd, 2008 @ 11:28 am
58. James

BTW my call on April 14th (the stock market is at the end of a grand super cycle advance and I wouldnt be investing for the long term) appears to be right on the money. Your welcome.

Oct 10th, 2008 @ 4:09 am
59. Dudley Brown

My wife is a dual citizen. We have a small home in her country of origin and want to sell it. Of course, we’ll have to pay taxes on it there, but will we have to pay capital gains taxes on it here in the US? This home was our residence there until we returned to the US a little over 2 years ago. We had a rental home in the US which is currently our permanent home.

Thanks.

Dudley

Oct 12th, 2008 @ 2:23 am