Capital Gains Deduction
Disposing of capital property often gives rise to a capital gain which must be reported on your income tax return. The current inclusion rate for capital gains is 50% which means that half of the capital gain is taxable at your marginal tax rate. A capital gains deduction may be available on the disposition of certain properties to reduce or eliminate the taxable capital gain.
The capital gains deduction may be available when individuals dispose of qualified small business corporation shares and qualified farm or fishing property. The deduction is not available to corporations, but it may be available to beneficiaries of a trust which owns the property. The individual must be a resident of Canada throughout the year of disposition. The deduction may also be available if you were a resident for part of the year of disposition but were a resident throughout the year either before or after the disposition. This rule allows for immigrants or emigrants to access the deduction.
Ensuring your property is eligible for the deduction is a crucial planning point. The definitions of qualified small business corporation shares and qualified farm or fishing property are complex. Qualified small business corporation shares have many conditions which must be met. First, they must be shares of a Canadian-controlled private corporation. Public companies, foreign companies or Canadian companies controlled by non-residents are not eligible. Second, the following asset and ownership tests must be met:
At the time of the disposition, 90% or more of the fair market value of the assets of the company must be used in an active business in Canada.
During the 24 months preceding the disposition, 50% or more of the fair market value of the assets of the company must be used in an active business in Canada. Also, during this period, the shares must belong to the taxpayer, a partnership of which they are a member, or a person related to the taxpayer.
The above conditions require us to plan accordingly for a disposition. It is critical that you meet the ownership requirement of at least two years to qualify. You must also ensure that any non-active assets, such as excess cash or investments, do not exceed 10% of the total fair market value of all assets at the time of disposition. These assets can be extracted from the company prior to the disposition, such as by paying dividends to the shareholders or transferring to a holding company, to ensure eligibility.
Qualified farm or fishing property commonly includes:
A share of the capital stock of a family-farm or fishing corporation.
An interest in a family-farm or fishing partnership.
Real property, such as land, buildings, and fishing vessels.
Eligible capital property such as milk and egg quotas, or fishing licenses.
Similar to qualified small business corporation shares, certain asset and ownership tests must be met for the qualified farm or fishing property. During the 24 months prior to the disposition, the individual, a partnership of which they are a member, or a person related to the individual must have owned the property during this time. During a period of at least 24 months during the period of ownership (any 24-month period, not necessarily the 24 months prior to the disposition), one of the following tests must be met:
Gross revenue and actively engaged test: The gross revenue from the farming or fishing activity must exceed the income from all other sources for the year, and the eligible individual must have been actively engaged in the farming or fishing activity on a regular and continuous basis.
Asset use test: The property must have been used by a family farm or fishing corporation or partnership in which the above-noted individuals are actively engaged in a regular and continuous basis.
These conditions ensure that access to the capital gains deduction is limited to farmers and fishers who are primarily engaged in these activities. Those with investments in farming or fishing activities, or those earning ancillary income from farming or fishing, will not qualify.
Assuming you meet the above conditions and your property qualifies for the deduction, there is a lifetime capital gains exemption that must be shared amongst all eligible dispositions. The lifetime limit for qualified small business corporation shares is $892,218 as of 2021 and this amount is indexed to inflation. The lifetime limit for qualified farm or fishing property is $1,000,000. The capital gains deduction available is currently 50% of these lifetime limits since the current inclusion rate for capital gains is 50%. These are shared limits so if you have utilized the full $1,000,000 on farm or fishing property, then you will not be able to utilize the deduction on the disposition of small business corporation shares.
The calculation of the annual deduction is complex. Items such as your cumulative net investment loss and allowable business investment losses claimed in prior years may reduce the amount you are allowed to claim. The deduction will also be impacted by any capital gains reserve that you may claim.
The capital gains deduction offers the ability to earn significant tax-free income. There are many conditions that must be met to access this deduction and the calculations for the annual deduction and the lifetime limit can be very complex. Detailed planning must be done to ensure your disposition qualifies for this beneficial tax treatment.
For more information, please contact firstname.lastname@example.org or 1 844-GYTD-CPA