Prepare for a possible hike in capital gains taxes

The budget is still two weeks away, but many experts are speculating the government will increase the capital gains inclusion rate from 50% to 66.67%, or even as high as 75%. What does this mean for investors? Those that have unrealized capital gains could be on the hook to pay more tax. “If they increase, the tax rate will be much closer to the dividends tax rate,” explains Kevin Stienstra, senior manager, Tax Services, Grant Thornton in Beamsville, Ont. For Ontario clients in the top tax bracket, Stienstra notes a 66.67% inclusion rate would increase the tax rate on capital gains from 26.77% to 35.69%. If the inclusion rate rises to 75%, the capital gains tax rate for those clients would jump to more than 40%, which is higher than the tax rate on dividends. Read: Are share buybacks good for your portfolio? “This would totally change the tax landscape,” he says, adding it would be a loss of a tax-planning opportunity for advisors, who often suggest converting dividends to capital gains. (To do this at the corporate level, trigger a disposition of corporate-owned assets, which creates room in the capital dividend account to flow tax-free dividends to the shareholder. To trigger gains at the shareholder level, sell shares to non-arm’s length individuals, which permits the extraction of cash from a corporation at capital gains rates.) If the government does increase the rate, advisors and clients will have to revisit investment strategies. “Look at investments that generate good dividend returns, instead of ones that grow in capital,” he says. So, dividend stocks might become more popular than growth ones. Read: When diversification drags returns In the meantime, Stienstra says clients who were already planning to trigger capital gains this year may want to do so before March 22 so they’re guaranteed the 50% inclusion rate. “For investments [like stocks from public companies], it’s not that much trouble to sell. And you can buy them back later.” Owners of private corporations who are planning to sell to a third party can take steps to realize gains now as well, he says. “They could consider selling shares to a related party, or do an internal restructuring to trigger that capital gain and bump up the adjusted cost base of their shares. That way, they increase their cost base at only 50% instead of potentially higher after the budget.” But clients who aren’t planning to realize gains in the near future should stay the course. “You’d be triggering gains based on speculation, and paying tax you would’ve otherwise been able to defer,” he says. “So you’ve got to look at the time value of money as well.” Meanwhile, those with unrealized capital losses are better off waiting until after the budget. “If you end up with a 75% inclusion rate, using that net capital loss to offset any gains will be much more valuable to you.” Read: Think twice before tossing old tax records Overall, experts hope the Liberals leave capital gains alone. “I really hope the government doesn’t do this, but the temptation to do so might be large given the current economic conditions and the disparity in tax rates,” Kim Moody of Moodys Gartner Tax Law notes in his recent blog. Adds Stienstra, “A 50% inclusion rate encourages investors to take more risk with their accumulated capital, thereby growing the economy in the process.” He suggests an alternative would be taxing capital gains similar to how they’re taxed in the U.S. – short-term gains (less than one year) are taxed as ordinary income, while long-term gains have about a 50% inclusion rate. “I think that would be a better option,” he says. This story was originally published on Advisor.ca