Capital Gains Tax: What you need to know
Updated: Jan 28, 2021
It was the great Ben Franklin who said there are only two certainties in life; death and taxes. Taxes are a part of every working persons life. If you try to avoid them and get caught, you'll get thrown in the slammer. There are several celebrities that have tried this and failed. Don't be like them.
While it may be illegal to avoid paying taxes all together, you most certainly should try your best to minimize them. Minimizing what you pay in taxes will leave you with more money in your bank account at the end of the day, but it can be difficult to do if you have no idea how the tax system works.
The tax system is very complex and I won't pretend to know how it all works. One thing that I am starting to learn is that the tax system favours business owners and investors. There are several tax advantages available to business owners and investors alike. I'm not going to list them all, because quite frankly I don't know them all. Does anybody?
In this post we're going to cover one particular tax; capital gains. I'll explain what a capital gain or loss is, the capital gains tax rates across 3 major countries, and give you a few strategies you can use to minimize or even eliminate the need to pay any capital gains tax (CGT).
What is a capital gain or capital loss?
A capital gain is an increase in value of an asset. If you think of capital as your money it makes it a bit easier to understand. So you are seeing a gain on the money (capital) you've invested. An asset can be stocks, bonds or real estate just to name a few.
The gain is considered to be realized when you sell the asset. A capital gain may be short term (one year or less) or long term (greater than one year) and can be subject to different tax rules.
A capital loss is a decrease in the value of an asset from the price that you paid for it. Same as the capital gain, it's considered to be a realized loss when you sell the asset. When you incur a capital loss, the loss can be used to offset any capital gains which will reduce your taxable income by the amount of the capital loss.
In a perfect world we would like to see all gains and no losses, but in reality we are likely to see both over our investing lifetime and a capital loss -while not ideal - can still be beneficial for you tax situation at times.
Capital gains tax rates - US, Canada, Australia
Short-term capital gains are taxed as ordinary income at rates up to 37%; long-term gains are taxed at lower rates, up to 20%.
The long-term capital gains tax rate is 0%, 15% or 20% depending on your taxable income and whether your single, married, etc. Most of the time the long term rates are lower than short-term capital gains tax rates.
There are special rules for certain types of long term capital gains such as art and collectibles, and they are taxed at ordinary income tax rates up to a maximum rate of 28%. You can avoid capital gain tax all together for the sale of your primary residence if you've lived in it for at least two years (doesn't have to be consecutive years either).
in the US, 100% of the gain is taxable, unlike Canada which only applies capital gains tax to half (50%) of the gain.
When investors in Canada sell a capital asset for more than they paid for it the Canada Revenue Agency (CRA) applies a tax on half (50%) of the capital gain amount. This is called the "inclusion rate".
For example; if someone bought shares for $10,000 and sold them for $15,000, the total capital gain amount would be $5000, and they would pay the marginal tax rate (the tax rate you pay on an additional dollar of income) on the $5,000 capital gain. The taxable capital gain would be $2,500 which will be taxed based on the individual’s tax bracket.
The inclusion rate for the capital gains tax is the same for everyone, but the amount of tax you pay depends on your total income, personal situation and your province of residence.
When you sell your home, you may realize a capital gain. If the property was solely your principal residence for every year you owned it, you do not have to pay tax on the gain. If at any time during the period you owned the property, it was not your principal residence, you might not be able to benefit from the capital gain tax exemption on all or part of the capital gain that you have to report.
All assets you’ve acquired since tax on capital gains started back in 1985 are subject to CGT unless specifically excluded.
Most personal assets are exempt from CGT, including your home, car and personal use assets such as furniture.
CGT also doesn’t apply to depreciating assets used solely for taxable purposes, such as business equipment or fittings in a rental property.
In Australia, the CGT is calculated by treating capital gains as taxable income in the year the asset was sold. If you have held that asset for more than 12 months, the gain is first discounted by 50% for individual taxpayers.
How to minimize your capital gains tax
There are some ways to minimize the tax you have to pay on a capital gain and in some cases you can avoid paying capital gains tax all together.
One of the best ways to lower how much you have to pay for capital gains tax is to simply hold the asset for longer than 12 months. This puts you into the "long term" category and you'll be taxed at a more favourable rate in most cases.
Another strategy is to incur a capital loss in the same period as you do the capital gain. This loss can be used to offset a portion or all of the capital gain. This is more common in the stock market and is referred to as "tax loss harvesting".
If you decide to sell your primary residence that you've lived in for more than 2 years you can avoid paying capital gains tax all together. This is one of the rare situations where the gain is completely tax free!
It's also worth noting that if you buy investments such as stocks and/or bonds in a mutual fund (preferably an Index fund with low asset turnover) and hold them forever you will never be subject to capital gains tax even if the value of those assets rise - although you will have to pay income tax on any dividends you receive but that's a topic for another blog post.
I know that tax isn't the most sexy financial topic to talk about, but it is one of the most important. Tax is the single biggest hit you take to your income so we should always do our best to minimize what we need to pay - but never avoid it, unless you want to end up in the slammer for tax evasion.
If your assets go up in value that is a good thing and it's what we all want at the end of the day. Depending on where you live in the world you will be subject to different rates of capital gains tax, but in general if you hold your assets for longer than a year this will be your best bet in keeping your capital gains tax as low as possible.
Blake - FIRE with a family