Capital Gain

The simple formula behind every capital gain

Every capital gain, whether it comes from a share, a cottage or a small business, is the same subtraction: proceeds of disposition, minus adjusted cost base, minus selling costs. The proceeds are what you received for the asset. The adjusted cost base (ACB) is what it truly cost you, including purchase commissions and, for property, capital improvements. Selling costs are things like commissions and legal fees on the way out. If the result is positive, you have a capital gain; if it is negative, you have a capital loss.

What happens to that gain at tax time is a separate story, told in the capital gains tax entry: how the gain lands on your return, the averaging rules for identical shares, deemed dispositions and the rest. In one sentence, the headline is this: only half of a realized gain is added to your taxable income, a fraction called the capital gains inclusion rate, which makes capital gains the most gently taxed way to grow money outside a registered account.

Realized vs unrealized: paper gains are not income

A gain only exists, in the eyes of the tax system, once you realize it by selling. If your portfolio is up $50,000 but you have not sold anything, that $50,000 is an unrealized or paper gain. It is not income, it appears nowhere on your tax return, and no tax is due on it. It can also shrink or vanish before you ever sell, which is the other sense in which a paper gain is not yet real.

The flip side of that rule is quietly one of the most powerful features of investing in Canada: you choose when the tax happens. Hold a winning investment for 20 years and the growth compounds untouched the whole time, tax deferred simply because you did not sell. This deferral is the built-in superpower of buy-and-hold investing. A frequent trader realizes gains constantly and pays tax on each one, while a patient holder of the same investments lets the government's share ride alongside their own, working for them until the day they finally sell.

Where capital gains show up for Canadians

Capital gains are not just a stock market concept. For most Canadians they arise in four places:

• Stocks, ETFs and funds: selling a stock or fund units in a non-registered account for more than your ACB, the everyday case.
• Real estate: a cottage, a rental property or land sold above its cost, with the important exception of the family home covered below.
• A business: selling shares of a company you built, or its assets, typically produces a capital gain on the growth in value.
• Foreign currency: even money itself can produce a gain; if you hold US dollars and the exchange rate moves in your favour before you convert back, the profit beyond the first $200 in a year is a capital gain.

Your home: the principal residence exemption

The largest capital gain most Canadian families will ever have is the one on their house, and in most cases it is entirely tax-free. The principal residence exemption shelters the gain on a home for the years it is designated as your principal residence, which for a family with one home is usually every year of ownership. It is one of the most generous features of the Canadian tax system, and it is a big part of why home equity plays such an outsized role in Canadian household wealth.

Two things are worth knowing so the exemption works as expected. First, since 2016 you must report the sale on your tax return and designate the property, even when the exemption wipes out the whole gain; the exemption is claimed, not automatic. Second, a family unit can generally designate only one property per year, so a household with both a house and a cottage cannot shelter both for the same years. The rules have edges, particularly around second properties, rentals and quick flips, so if your situation is anything other than one family selling one long-held home, it is worth reading the capital gains tax entry or getting advice.

Gains inside registered accounts

Inside a TFSA, capital gains simply never exist for tax purposes. Sell a winner for ten times what you paid and nothing is reported, nothing is taxed, ever. It is the cleanest treatment a gain can get.

Inside an RRSP, gains are sheltered while they grow, but the honest accounting is different: every dollar eventually withdrawn is taxed as regular income at your full marginal rate. A capital gain earned inside an RRSP therefore trades its lightly taxed 50% inclusion treatment for fully taxed withdrawal treatment later. That is not a reason to avoid the RRSP, because the upfront deduction and decades of tax-free compounding usually more than make up for it, but it is a reason growth assets are often held in the TFSA first when you have room in both.