Investors across Canada may be considering whether they ought to trigger their capital gains before they are taxed at a higher inclusion rate.
As of June 25, the inclusion rate will rise to two-thirds from one-half for individuals on capital gains above $250,000 each year. In Ontario, for example, the new rules will raise the tax rate on capital gains at the highest tax bracket by 8.9 per cent.
Many Canadians may be sitting on significant capital gains built over several decades. As an investment adviser and portfolio manager, I see client holdings with unrealized gains of 200 per cent, 300 per cent, 400 per cent, and higher.
Is it time to sell now? After all, if it’s a good holding, can’t we repurchase it soon after? Can’t we pay the taxes at the lower rate now and thus save in the future from paying a higher rate?
There are three factors to be aware of which will determine what you should do now. The first is the expected hold period. How long would you have planned to hold this investment? The second is expected annual return. What percentage gain are you anticipating over the coming years? And the final factor is what is your current unrealized capital gain as a percentage?
Putting these three data points together: The longer your future hold period, the more significant your anticipated annualized gains, and the more significant your current unrealized gain, the better you are holding through and not realizing the gain at this time.
Conversely, if your expected hold period is short, projected future returns are low, or your current unrealized gain is modest, selling before the new rate takes effect could be advantageous.
Here is an example. Betsy is 59 and has accumulated an extensive portfolio of stocks. Some are growth stocks, anticipating double-digit annual growth well into the future, and others are mature dividend stocks with low expected future gains. She has expressed her desire to keep the current portfolio till age 69.
Considering that these holdings have accumulated significant unrealized gains, she is wondering if she should realize the gains now and pay the current top tax rate, then reinvest the balance in the same holdings. In this scenario, her work income places her in the top tax bracket, and owing to her large asset base, she sees future realized gains from these holdings being over and above the $250,000 mark.
Let’s analyze some of Betsy’s holdings based on the three factors listed above.
To begin, growth stock #1 has an adjusted cost base (ACB) of $330,000 and a market value of $1,000,000, which equals a 203-per-cent unrealized gain accumulated over many years. The anticipated growth over the coming 10 years is 12 per cent annually.
We have two routes to take. If we leave it invested and the 12 per cent anticipated return materializes as expected, the holding will be worth $3,105,848. After paying capital gains taxes at the new rate, Betsy’s take-home in 10 years will be $2,115,231.
Or we could trigger the gain now, pay the tax at the current lower rate, and reinvest the balance. The new adjusted cost base would be $820,675. The value in 10 years will be $2,548,890, and Betsy’s take-home after the future tax is $1,932,142.
The difference between the take-home value in Route 1 and Route 2 is 9.47 per cent. If Betsy tries to save on taxes by paying them now, she will effectively be 9.47 per cent worse off.
Now, let’s take a look at growth stock #2. This one has an expected future annual return of 14 per cent, an ACB of $200,000, and a current market value of $1,000,000, equalling an unrealized gain of 400 per cent accumulated over several decades.
Taking the same two route options as with growth stock #1, and calculating out 10 years, we come to a difference of 14 per cent. If Betsy pays the tax now at the current rate, her future take-home amount will be lower by 14 per cent.
Now, let’s look at dividend stock #1, a mature company paying a healthy dividend but with only 4 per cent expected growth in capital gains. Its ACB is $500,000; it’s market value is $1,000,000. Projecting out 10 years, taking the two routes outlined, we get:
If we keep it invested, the value will be $1,480,244. After paying the new capital gain tax, the net value will be $1,130,425. If we realize the gain now and invest the after-tax balance for 10 years, we get a new ACB of $866,175 and a future after-tax value of $1,133,701.
Alternative minimum tax issues aside, Betsy will be better off triggering the tax now. She will gain $3,277 by realizing the gain before June 25. Percentage-wise, if she holds through, she is worse off by 0.29 per cent.
If Betsy’s expected future hold period is five years, the above outcomes would be as follows:
Growth stock #1: the advantage of holding through is 2.3 per cent.
Growth stock #2: the advantage of holding through is 4.5 per cent.
Dividend stock #1: the disadvantage of holding through is minus-2.6 per cent.
In summary, navigating the lower capital gains inclusion rate requires a comprehensive analysis of each investment’s characteristics and each investor’s financial objectives. By weighing the interplay of tax considerations and investment outcomes, you can make informed decisions to optimize your portfolio for long-term growth and wealth preservation.
Dov Marshall, CFP, CLU, CIM, is a Portfolio Manager with Aligned Capital Partners Inc. (“ACPI”). His e-mail is DMarshall@alignedcp.com. This material is provided for general information and the opinions expressed are those of the author and not necessarily those of ACPI. Every effort has been made to compile this material from reliable sources, however no warranty can be made as to its accuracy or completeness. Before acting on the information, please seek professional financial advice based on your personal circumstances. The figures provided are for illustrative purposes only to provide an example of the author’s process and methodology. The results portrayed are not representative of a real client’s experience. ACPI is regulated by the Canadian Investment Regulatory Organization (“CIRO”).
Editor’s note: An earlier version of this article misstated the waiting period for an investor to repurchase assets after realizing capital gains. This version has been corrected.