What are capital gains?
The term capital gains refers to increases in the value of an investment. That includes securities like stocks but also things like real estate. So if you buy a stock for $50 and sell it for $80, that’s a $30 capital gain.
Thankfully, you pay tax only on realized capital gains. Gains are realized when you actually sell your investment for more than you paid for it. While you’re still holding on to your investments, any gains are unrealized and won’t incur extra taxes.
On the flip side, if your investment decreases in value from its original purchase price, it’s called a capital loss.
You don’t have to worry about other sources of investment income, like interest, dividends or rent from properties you own. Same goes for the sale of your home, as long as it’s been your principal residence every year you’ve owned it.
What is the capital gains tax?
Technically speaking, there’s no such thing as a "capital gains tax" in Canada. But you do pay income tax on capital gains.
Half the value of your capital gains is taxable, so you simply add 50% of your gains to your regular income. It’s your income as a whole that gets taxed every year.
So if you earn $50,000 from your job and made $10,000 from selling investments — very impressive — you would be taxed as if you made $55,000 that year.
Keep in mind, these are the rules for ordinary people. If you’re a full-time suit-and-tie big-city investor and most of your income is made up of capital gains, the Canada Revenue Agency (CRA) could decide to tax you the full rate.
How to calculate tax on capital gains
First, figure out the “adjusted cost base” — the original purchase price of the investment, plus any extra costs it took to acquire it, like brokerage fees. Then take the sale price and subtract any costs associated with selling the investment.
Find the difference between those two numbers, and there’s your profit — the capital gain that you’ll need to pay tax on. Remember, you only add half this value to your total income tax.
Pretty simple, but things can get confusing if you buy shares of a company at one price, then pick up more later at a different price. In that case, you need to calculate the average to find the adjusted cost base.
Let’s say you bought 10 shares of a company at $30 each, and you needed to pay $15 in fees. That would be $300 plus $15, or $315. Later, you bought 10 more shares of the same company at $50 each and paid another $15 in fees. That would be $500 plus $15, which equals $515. Add the two costs together ($315 plus $515 equals $830) and divide it by the total number of shares (20). You get $41.50 per share.
If you ended up selling, say, 15 of your shares at $70 each, you’d collect $1,050. If you had to pay another $15 fee to make the sale, you’d have $1,035 left over. So your final capital gain would be:
$1,035 - ($41.50 x 15) = $412.50.
How to avoid tax on capital gains
There are two main ways to hold on to more of your profits.
Not all investments work out. While it stinks to lose money, you can actually use those capital losses to offset the tax you pay on your capital gains.
You simply subtract your capital losses from your gains to determine your net capital gain for the year, assuming your gains exceed your losses. (Otherwise, you’re looking at a net capital loss.) That will reduce the amount you need to add to your income.
The CRA allows taxpayers to apply losses retroactively, up to three years back in time, or carry them forward into future years, indefinitely. However, if you have both capital gains and capital losses in the same tax year, you must use the loss to offset those capital gains.
Tax-loss harvesting is a handy technique, but you usually don’t want to sell at a loss just for the tax benefit. It’s often better to wait for the value to bounce back.
And don’t try to cheat by selling a stock at a loss, then buying it back right away. That won’t go down well with the CRA. However, you could sell a stock at a loss and then buy one in the same general sector — say, fossil fuels — allowing you to reap the benefits if the sector recovers.
Keep in mind, tax-loss harvesting only works in taxable investment accounts. You can’t use it if you’re already investing through a sheltered plan. That’s a whole separate technique.
You might have one of these already. These special accounts don’t care about the capital gains that happen inside them, so you can sell your assets totally tax free. You only pay when you cash out and money leaves the account.
Registered Retirement Savings Plans (RRSPs) allow you to shelter your money and investments until your golden years, when you should be in a much lower tax bracket.
Registered Education Savings Plans (RESPs) let parents save up for their kids’ education. In addition to shielding your investments, you also get free money in the form of grants from the government.
Your employer might have a Registered Pension Plan (RPP) and offer to match your contributions toward your eventual retirement.
Unlike the other plans, Tax-Free Savings Accounts (TFSAs) let you withdraw money at any point without penalty. You can use one to save up for a new car or keep it as an emergency fund.
How to open a tax-sheltered account
If you don’t already have one, you can open a tax-sheltered account with your bank or another financial institution. They’re easy to set up and have plenty of benefits besides dodging capital gains tax.
These automated platforms will build you a portfolio of low-fee investments based on your tolerance for risk, then automatically make adjustments as the market shifts. You can open TFSAs, RESPs and RRSPs — plus, premium Wealthsimple Black clients get access to automatic tax-loss harvesting in their non-registered accounts.
It can be hard to figure out when to hold on to a flagging investment and when to sell, but a robo-advisor can run the numbers and make those decisions for you. New users get their first $10,000 managed for free for an entire year, making Wealthsimple one of the easiest ways to get started.
Correction — Jan. 13, 2021: This article has been updated from a previous version that used an incorrect example to illustrate capital gains tax.