The surprise over the Federal government’s decision to increase the capital gains inclusion rate in the 2024 budget has mostly subsided, but now investors, entrepreneurs and their advisors must determine how that change might impact their portfolios.
The key question most are pondering is whether to realize gains before June 25, when the inclusion rate is proposed to increase to 66.67% from 50% for capital gains. (However, for individuals, anything below the $250,000 threshold will continue to be taxed at the current 50% inclusion rate.) The answer will depend in part on whether you’re selling an asset as an individual or within a corporation.
Individual impact
While it may be tempting for those who have accrued more than $250,000 in unrealized capital gains in market-based securities to sell now and realize gains at the lower inclusion rate, John Waters, Vice President and Director of Tax Consulting Services at BMO Private Wealth, said that for most individuals it’s better to do nothing and continue investing those assets than liquidate and reinvest those dollars.
Say you have a $2 million portfolio, with $1 million in unrealized capital gains. If you sold that entire amount today, you would pay approximately $250,000 in capital gains taxes at the top marginal tax rate, leaving you $1.75 million to reinvest in a similar portfolio of assets. Assuming a 5% annual rate of return, by 2036 you could have a total portfolio value of nearly $3.14 million, which would result in an after-tax value of nearly $2.7 million after liquidation (at the proposed 2/3 inclusion rate).
By comparison, if you held onto those assets for the same 12 years, earning the same rate of return, your portfolio would be worth almost $3.6 million. If you deferred realizing the capital gains on your portfolio until 2036, you could have almost $2.75 million after tax, or almost $50,000 more than if you exited before this year’s June 25 deadline.
“There is a breakeven point where it becomes better to do nothing and continue to hold because of the time value of money and the accumulation that’s being generated,” explains Waters. “In the do-nothing scenario, you’d have a bit of a head start because you’re investing the full $2 million for future growth, where if you sell, you’re paying the tax and investing a lower amount.”
The annual $250,000 threshold available to individuals provides access to the current 50% inclusion rate below this threshold. Accordingly, Waters also points out that there are a variety of tax-planning strategies individuals can employ to stay below the $250,000 threshold amount. For instance, you may be able to time the sale of your assets so that you don’t trigger a higher inclusion rate each year. And while the exact details around how the new inclusion rate will work haven’t been revealed, it’s likely the $250,000 threshold will apply to all individuals, meaning there could be income-splitting opportunities for couples. “Most individuals may therefore want to keep the status quo,” he says.
When it comes to a cottage or a second property, however, it could make sense to sell now so you don’t end up paying more in capital gains later, Waters notes. “If you’re already in that process, or if you were looking at transferring a property to the next generation either as a sale or a gift, then that may be something to think about accelerating,” he says.
Divesting a property on short notice can come with other challenges, though. Even at a lower rate, you’ll still need cash to cover the tax bill, which you may or may not have, while other taxes, such as land transfer fees, may also need to be covered. Also, if you transfer a property, such as a cabin, to the next generation while you still want to use it, you’ll have to sort out access rights with the now cottage-owning family member.
Corporate considerations
With business owners, decisions around when to realize gains are much more complicated, says Dante Rossi, Director of Tax Planning at BMO Private Wealth. While it’s always a good idea for anyone to talk to a tax expert before making any moves, because of how cash both inside and outside of a corporation gets taxed, entrepreneurs have to be extra careful when making financial decisions. “Because the corporation is a separate taxpayer distinct from its individual shareholder, it earns income separately and results in two layers of tax on that same source of income,” says Rossi.
Some owners of investment holding companies, he says, are considering winding up their corporations before June 25 and distributing the after-tax proceeds to their personal accounts. That way, they can get access to the personal 50% capital gains inclusion rate on up to $250,000 of capital gains annually, which would give them more flexibility to realize gains.
While this may be a sound strategy for some, it’s not for everyone and needs to be carefully considered, because of the corporate and personal taxes that a wind-up would entail. Rossi likens it to withdrawing all your assets from a Registered Retirement Savings Plan (RRSP) at one time. “Winding up the company would effectively mean the end of that personal tax deferral,” he explains. “It’s like collapsing an RRSP in one fell swoop – it may not be the best idea.”
There may also be changes to the way the capital dividend account (CDA) is credited. It’s expected that the CDA inclusion rate will fall to one-third from one-half after June 25, which will result in “less credit to the CDA, which provides the ability to pay out tax-free dividends to Canadian resident shareholders,” says Rossi. “This could be another driving factor in triggering some of those gains now on dispositions of securities within an investment holding company.”
If you own a professional corporation, you’ll want to talk to an advisor, too, as tax planning is getting even more complicated. One significant benefit of having a professional corporation, or even a small business, is that active business income below $500,000 is taxed at a preferred rate – just 9% federally. However, that number gets clawed back if you earn more than $50,000 in passive income within the corporation (or amongst an associated group of companies). If you’re earning $150,000 of passive income, then you don’t get to benefit from that $500,000 preferred tax rate at all, says Rossi.
Until now, only 1/2 of a realized capital gain would be included in the passive income calculations, but after June 25, that number will rise to 2/3. “That will have a greater impact on that small business deduction grind, potentially reducing the benefit of that small business tax rate,” he explains.
A higher capital gains inclusion rate may have other implications to the charitable community – for instance, it could now make more sense to donate appreciated publicly traded securities in-kind from a corporation versus individually when you take into account the impact of the Alternative Minimum Tax (AMT) that applies only to individuals, says Rossi – which is why you’ll want to have a comprehensive discussion with your advisor about how the changes could impact your charitable giving strategy and related tax savings.
Finally, since the changes are only proposals at this stage with no draft legislation yet released, caution is warranted before proceeding with any tax-motivated transactions until details regarding the specific application of these proposals are known, further highlighting the need to consult with your tax advisors for assistance in your situation.
