The federal deficit has been soaring because of massive spending on COVID relief and new programs. That has many observers warning tax increases are on the way for Canadians in the next budget.
A lot of speculation has centred on whether the government will target capital gains for higher taxes. This has led some people with a lot of accumulated capital gains to wonder if they should sell assets now to take advantage of the current tax rate before it goes up.
Talk of an increase in the capital gains tax is nothing new. For at least the last five years, it’s been a theme in commentary before federal budgets. But over the last year, the speculation has been particularly intense because of the rapid increase in the federal deficit.
Before we discuss crystalizing capital gains now to avoid higher taxes later, let’s take a look at what capital gains are and how they are taxed in Canada.
Capital gains are the increase in value of an asset such as an investment or a piece of real estate over time. A capital gain is realized when the asset is sold or considered to have been sold by the government.
Capital gains are only collected on investments held in non-registered accounts. In Canada, only half of your capital gains are taxable at your marginal tax rate. For Quebec residents who earn more than $221,708 per year, the combined federal/provincial marginal tax rate for capital gains is 26.65% in 2022.
That only 50% of your capital gains are taxable is known as the capital gains inclusion rate. How high could the inclusion rate go? Well, the federal NDP has proposed an increase to 75%. But the government could even push it to 100%, meaning every dollar of gain would be taxed at your marginal rate.
Past governments have raised the capital gains tax. In 1988, the Conservatives raised the inclusion rate to 66.67% from 50%. They then boosted it again to 75% in 1990. It was the Liberals who lowered it back to 50%.
Of course, people would like to avoid a potential tax hike if they could. You might be able to do this by selling assets and triggering capital gains at the current rate to avoid paying a higher rate if the government goes through with one. Is that a smart strategy? I don’t believe so for a couple of reasons.
First—and most importantly—selling your assets to avoid higher capital gains taxes could end up costing you a lot of money.
A fundamental principle of financial planning is that you should defer taxation whenever you can. This is because the money continues to grow during the years it hasn’t been paid to the government. And when it comes time to pay the tax in the future, you may be in a lower tax bracket.
With the capital gains tax, you don’t pay until you sell the asset. Therefore, gains accrue on the full amount of your investment, including the taxable portion embedded in the capital gain.
Conversely, once you sell the asset and pay the tax, you are no longer benefitting from growth on the portion you have paid in tax.
The second reason I don’t like the strategy is we have no way of knowing if or when the government will go through with a capital gains tax hike.
After all, fears of an increase have not come to pass in recent years. I agree that taxes are likely going up, but there are all sorts of other places the government could choose to make us pay more.
Now, I’m not predicting the capital gains inclusion rate won’t go up. Just that we have no way of knowing in advance if it will or when it will. And a bet on a tax increase gets more costly every year the government doesn’t go through with the move.
Of course, there are other reasons you may want to realize capital gains, including a simple desire to sell an asset or a need to do so.
You might also want to sell some investments to rebalance your portfolio. Or perhaps you can offset some of your gains with capital losses. (While you can’t claim a capital loss in the year it occurs, you can carry it back up to three years to recover past taxes paid on capital gains, or you can carry it forward indefinitely to offset capital gains in the future.)
Another possibility is that you have lower income in one year than another, making it a good time to realize some gains.
These are all good reasons to crystallize capital gains. Taking a roll of the dice on a future tax change is not one of them.
Managing capital gains and other taxation issues is a key part of financial planning. It’s important to get advice from an investment advisor to help you make the right decisions.