Canada's federal budget 2024 has proposed an increase in the capital gains tax rate in certain cases this means that selling a taxable asset like a business a secondary real estate property or an Investment Portfolio May cost more to make things more interesting capital gains realized before June 25th will be taxed at the old lower rates this opens the door for Smart Financial Planning and the potential for mistakes I'm Ben Felix portfolio manager at pwl Capital and I'm going to tell you what an increased capital gains tax rate means for your Investments a capital gain arises when you sell an asset for more than its adjusted cost base which is what you paid for the asset plus any expenses related to acquiring it if you buy a stock for $10,000 and later sell it for $115,000 you have a $5,000 capital gain capital gains in Canada were not taxed at all prior to 1972 since 1972 the top combined Federal and provincial capital gains rate for individuals in onario has been as high as 39% in the 1990s and as low as 23% in the 2000s the 2024 budget proposal would set the top capital gains tax rate for individuals in Ontario at a little more than 35% the variation in the capital gains tax rate over time is largely due to changes in the capital gains inclusion rate in Canada the full capital gain is not included in your taxable income the amount that is included is dictated by the capital gains inclusion rate this is what the budget is proposing to increase the inclusion rate has been 50% since 2000 it was 75% from 1990 through 1999 66% in 1988 and 1989 and 50% before that the overall tax rate on a capital gain is simply the inclusion rate multiplied by your income tax rate while the capital gains inclusion rate and by extension the tax rate on capital gains is proposed to increase the first $250,000 of gains earned by an individual will be taxed based on the old 50% inclusion rate corporations which is where many small business owners and professionals do their investing are getting hit harder they do not get the $250,000 limit they pay tax at the new higher rates on their first dollar of capital gains corporate taxation in Canada is complex but by my calculations a capital gain realized in a corporation and flowed through to a shareholder will now be taxed at a total rate of 38.6 2% compared to the previous 28.97 per. again corporations do not get the $250,000 of capital gains at the old inclusion rates like individuals do for individuals many people will be protected by the fact that they can realize up to $250,000 of capital gains per year at the old 50% increase inclusion rate but this will likely still catch lots of people with second properties and larger investment portfolios and it will be particularly impactful in the year of death of the second spouse when all personal gains are realized employee stock options are similarly affected by these proposed changes if you have qualified employee stock options they previously received a stock option deduction for half of the stock option benefit and that is being decreased to onethird for amounts over $250,000 that $250,000 limit is shared by stock option income and capital gains the question a lot of people are asking is whether they should do anything before June 25th while they still have access to the 50% inclusion rate with no limit let's think about a basic example if you as an individual have a taxable asset worth $1.1 million and an adjusted cost base of $100,000 you have a $1 million capital gain I know those seem like big numbers but this could be an Investment Portfolio a family Cottage or a rental property paying the capital gains tax on that asset prior to June 25th would result in about 268 ,000 of tax at the top rate in Ontario paying the tax after June 25th would result in about $335,000 of tax that is obviously a big difference but I'll tell you why it's not obvious that everyone should be selling their taxable assets before June 25th selling now well resulting in a lower tax bill today also means that you have to pay that lower tax bill today if you're planning on selling the assets soon anyway it makes sense to do it on June 23rd instead of June 26th if you are not planning on selling though it's much less obvious deferring that tax bill into the future even knowing that it will be at a higher inclusion rate can still make sense if the opportunity cost of paying the tax now is high enough the opportunity cost will be a function of your expected investment returns and your tax rate we've been running these numbers at pwl trying to figure out what makes sense for people to do we set our modeling up to give us the break even year as an output this means that if you were planning on deferring your capital gains for some number of years the break even number of years you're better off deferring the gain rather than realizing it immediately at the current lower rates for example an asset worth $1.1 million with an adjusted cost base of $100,000 held by someone at the top Ontario tax rate with an expected return equivalent to a 100% Equity portfolio is better off deferring that capital gain for at least 7 years than realizing it today if they would otherwise sell before 7 years they're better off realizing the gain before June 25th to lock in the lower tax rate to be clear I am not suggesting that people go out and sell assets today this is very new information Professionals in tax and financial planning are still digesting the proposed changes and figuring out what to do next it's also a proposed change not yet law if it does pass into law we have until June 25th to figure it out so there is no immediate rush though to be fair some assets like businesses and real estate can take quite a while to sell it is important for people to understand the impact on their specific situation and plan accordingly let's not forget that for long-term investors real in large capital gains is not something that you're doing every year or at least it shouldn't be this will be even more true after June 25th but building tax efficient investment portfolios has always been important this is yet another reason that lowcost and low turnover Investments like index funds are useful tools actively managed funds tend to trade more and distribute more capital gains each year due to having higher portfolio turnover index funds don't trade much inside of the fund so they distribute very little capital gains this budget proposal does highlight one of the many reasons that just by vro is not a financial plan the literal action of purchasing a lowcost ETF has become very easy and it's an important step in implementing a broader financial plan but there's a lot more to consider financial planning considers how an investment interacts with things like retirement planning tax and Estate Planning and budgeting for large future purchases all of those items interact with an increased capital gains inclusion rate and may affect investment decisions the other thing that this highlights is tax rate risk we talk a lot about return UNC C but after tax returns are what put food on the table and changing tax rates can affect after tax returns an example of something that we do to mitigate this at pwl is realizing capital gains to use up clients low tax brackets in years that they have room available this helps to lower the eventual terminal tax bill and it reduces the risk of changes in future tax rates like the ones that we are seeing now similarly for people with corporations we typically recommend taking money out of the corporation to at least fund registered accounts like rrsps tfsas and RPS this results in tax diversification having money in multiple buckets with different tax treatment these little details are all part of the broader scope of portfolio management and financial planning and they can make a big difference in the long run I like to say that investing has been solved which is largely true a great portfolio is pretty easy for anyone to buy but investing is only one sliver of Good Financial Planning budget 2024 has proposed an increase in the capital gains inclusion rate capital gains realized after June 25th will have an inclusion rate of 2third as opposed to the previous one half on amounts over $250,000 for individuals and on any amounts for corporations this change will increase the top Ontario tax rate on capital gains from 26.7 7% to 35.6 n% for individuals and from 28.97 to 38.6 2% for people investing in their corporations in some cases it may make sense to realize capital gains before June 25th to get ahead of the rate increase but for many long-term investors this will do more harm than good thanks for watching ing I'm Ben Felix portfolio manager at pwl Capital if you want to learn more about how pwl applies tax awareness and long-term financial planning to portfolio management you can book a meeting with us below
