Capital Gains

Capital gains result when the value of your investment in stocks, bonds, real estate, and a wide variety of items considered to be capital property have increased in value since it was purchased. The cost of the investment is known as the Adjusted Cost Base (ACB).

In terms of tax effectiveness, capital gains are treated more favourably than interest and dividend income because only half of the gain is taxed at one’s marginal tax rate.

 A capital gain is the difference between the ACB and the selling price.  One half of the capital is taxed and this is known as a taxable capital gain.  The other half of the capital gain is tax-free.

Example

Index Fund is purchased for $100,000 and thereafter sold for $110,000

Capital gain = $111,000 – $100,000 = $10,000

Amount of taxable capital gains: $10,000 × 50% = $5,000

Amount of tax paid; $5000 × 46% = $2,300

Net return after taxes: $7,700

* Assuming 46% marginal tax bracket

In addition to the favourable tax treatment, capital gains also provide investors with the potential added benefit of tax deferral. Interest income, whether received yearly or on a compound basis, must be declared annually. Dividends are typically paid out quarterly and declared once annually. Capital gains are created only when an asset is sold in most cases.

It is important to understand that an investment that provides investors with potential capital gains can also provide investors with capital losses. However, even when an asset is sold for less than what was paid (a capital loss), that loss can be deducted from capital gain income earned in the previous three years or it can be carried forward indefinitely.

Investors should not solely make investment decisions based on how income is paid.  Investors should make investment decisions based on their overall investment objectives, time horizon, level of experience and tolerance to risk.  Although tax effectiveness is important, ensuring an investment is suitable is more important. 

Investors seeking tax advice should always seek professional help.

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