As a result of COVID-19 and numerous other economic factors, the fiscal climate going into 2021 is relatively uncertain. Canada and the U.S., along with essentially every other country in the world, have significant government deficits to repay. There has been much talk about how this will be accomplished, and an increase to capital gain tax rates is a commonly referenced possible solution. The below outlines the current tax treatment of capital gains in Canada and the U.S., the appetite for change in each country, and a few questions to ask your financial planner about realizing capital gains before December 31, 2020.
Current Treatment – Canada
In Canada, the current capital gains inclusion rate is 50%. This means that 50% of your net realized capital gain is included in your total income for tax purposes. Using an example, if you were to sell your investment portfolio with a cost of $100,000 CAD for $900,000 CAD, you would realize a capital gain equal to $800,000 CAD, resulting in $400,000 CAD of total income, and approximately $107,000 CAD of tax payable assuming you are subject to the top marginal tax bracket in Ontario.
The capital gains inclusion rate has not always been 50%, and before 1972, capital gains were not subject to tax at all. Instead, before 1972, there was a complicated system of federal and provincial estate and succession taxes, which were ultimately replaced by the capital gains tax. Since 1972, the capital gains inclusion rates have been as follows:
|Time Period||Inclusion Rate|
|1972 to 1987||50%|
|1988 to 1989||66.67%|
|1990 to February 27, 2000||75%|
|February 28, 2000 to October 17, 2000||66.67%|
|After October 17, 2000||50|
Current Treatment – U.S.
In the U.S., there are currently different tax rates for realized capital gains depending on how long you held the asset:
- If you held the asset for less than 1 year, it is considered a short-term capital gain and is subject to your normal federal marginal tax rates; and
- If you held the asset for greater than 1 year, it is considered a long-term capital gain and is subject to the following special federal tax rates depending on your filing status and annual taxable income for 2020:
|Filing Status||0% Rate||15% Rate||20% Rate|
|Single||Up to $40,000 USD||$40,000 to $441,450 USD||Over $441,450 USD|
|Head of Household||Up to $53,600 USD||$53,600 to $469,050 USD||Over $469,050 USD|
|Married Filing Jointly or Surviving Spouse||Up to $80,000 USD||$80,000 to $496,600 USD||Over $496,600 USD|
|Married Filing Separately||Up to $40,000 USD||$40,000 to $248,300 USD||Over $248,300 USD|
There is also currently a special 3.8% Net Investment Income Tax (“NIIT”) applied to realized capital gains if your modified adjusted gross income (including your realized capital gains) is greater than:
- $125,000 USD if filing as Married Filing Separately;
- $200,000 USD if filing as Single or Head of Household; or
- $250,000 USD if filing as Married Filing Jointly or Surviving Spouse.
Current Treatment – Dual Tax Resident
If you are a dual tax resident of Canada and the U.S., generally, the following rules exist regarding capital gains according to the Canada – United States Tax Convention (1980):
- The proceeds on the sale of real property should be sourced to the country in which the property was located; and
- The proceeds on the sale of property, other than real property, should be sourced to the country in which the seller is considered resident.
Appetite for Change – Canada
In Canada, the Liberal Party of Canada (“Liberals”) have formed a minority government as a result of the 2019 Federal Election. The Liberals have heavily relied on support from the New Democratic Party (“NDP”) to pass recent legislation relating to the COVID-19 stimulus. The Liberals and NDP have some similar political ideologies, and in their 2019 election platform, the NDP proposed to increase the capital gains inclusion rate from the current 50% to 75%. We should also note that another Canadian minority political party, the Green Party of Canada, proposed in their 2019 election platform that 100% of capital gains should be subject to taxation.
Going back to our example above, if you were to sell your investment portfolio with a cost of $100,000 CAD for $900,000 CAD, you would have a realized capital gain of $800,000 CAD. However, if the capital gains inclusion rate were to increase to 75%, this would lead to $600,000 CAD of taxable income and approximately $161,000 CAD of tax payable if you are subject to the top marginal tax bracket in Ontario. Therefore, you have sold the same asset for the same amount but have paid an additional $54,000 CAD (or 50%) of tax compared to the current rules.
Appetite for Change – U.S.
In the U.S., President-Elect Joe Biden (“Biden”) has proposed taxing realized capital gains at your ordinary marginal tax brackets if you earn more than $1,000,000 USD annually. Biden has also proposed increasing the top marginal tax bracket from 37% to 39.6% and limiting itemized deductions and the Section 199A Qualified Business Deduction for taxpayers with annual gross income greater than $400,000 USD. When the proposed top marginal tax rate of 39.6% is added to the NIIT of 3.8%, the marginal tax rate on capital gains can reach a total of 43.4%.
It is likely that in order for Biden to pass his proposed tax changes, the Democratic Party will have to gain control of the U.S. Senate in order to avoid a legislative gridlock with the Republican Party. The issue with this is that the control-determining Senate races will not be decided until a Georgia run-off on January 5, 2021 – which is too late to sell assets and realize capital gains for the 2020 taxation year.
The questions you should be asking yourself and discussing with your financial planner to determine whether you should trigger capital gains before December 31, 2020 are as follows:
- What assets do I have?
- How does each of these assets fit into my investment goals?
- How liquid is each of these assets?
- What is the adjusted cost basis of each of my assets?
- What is the fair market value of each of my assets?
- What is the unrealized capital gain or loss of each of my assets?
- Do I expect each of my assets to continue growing in value or to suffer a future decline in value?
- Have I already realized any capital gains or losses during 2020?
- Do I have any capital loss carry forwards from net capital losses incurred in prior years but not yet utilized?
- What is my estimated taxable income and marginal tax bracket for 2020?
- What is my estimated taxable income and marginal tax bracket for future years?
- Are any of my assets eligible for special tax treatment?
- Special tax treatment in Canada includes the Principle Residence Exemption and the Lifetime Capital Gains Exemption (see our previous Cardinal Point article for more details).
- Special tax treatment in the U.S. includes sales of collectibles, Qualified Small Business Stocks, Owner-Occupied Real Estate, and Investment Real Estate.
- Do I expect capital gain inclusion rates in Canada to increase or tax rates on capital gains in the U.S. to increase as a result of current political pressures?
Developing a tax efficient strategy to realize income from capital gains is critical. Whether you are a Canadian tax resident, U.S. tax resident, or a dual tax resident of Canada and the U.S., it is important to garner professional advice. Contact Cardinal Point to discuss the above noted questions and to complete a tax return projection.