Five kinds of income tax
When it comes to investment income, our tax system is a labyrinth. There are at least five different methods for calculating tax owed on investment earnings outside a registered plan, depending on the nature of the income. Here they are.
Interest income. Any interest earnings from bonds, GICs, money market funds, etc. are taxed at your full marginal rate, the same as regular salary. There are no breaks of any kind.
Dividends. Dividends are taxed at a much lower rate, thanks to the dividend tax credit. This credit is intended to reduce the effect of double taxation by recognizing that corporate dividends are distributed to shareholders out of after-tax profits. This means that a company has already paid tax once on the earnings. In theory, therefore, dividends should then be received tax free by investors, but our government is not that generous. The dividend tax credit is a compromise measure. To calculate the credit to which you’re entitled, you must first “gross up” the actual dividend you receive by multiplying the amount by 125 per cent. You then multiply that number by 13.33 per cent. The amount of the credit is deduct directly from your federal tax payable. Note that the dividend tax credit will only apply to dividends received from taxable Canadian corporations. Dividends from foreign companies aren’t eligible.
Capital gains. Only half of a capital gain is taxable. The other half is yours to keep. The same is true for capital losses; only half can be claimed. The source of the capital gain doesn’t matter. For example, U.S. stocks are not eligible for the dividend tax credit but they can be used to claim capital gains or losses in the same way as Canadian shares.
Return of capital. Many people aren’t familiar with this form of investment income, but it can be very attractive. The term refers to money that is paid to you which is not taxable in the year received. There are a variety of reasons for this; for example part of the money paid by a real estate investment trust (REIT) may be tax sheltered by depreciation on the buildings owned by the trust. In your hands, it’s tax-deferred return of capital.
Note that I used the term “tax-deferred”. This means that tax has been postponed until some future date, not avoided entirely. When you receive a return of capital payment, you must deduct the amount from the price you originally paid for the security that generated the distribution to arrive at an “adjusted cost base” (ACB). The ACB is used for calculating capital gains liability when you sell.
For example, suppose you paid $10 a unit for shares in a REIT. You receive a $1 return of capital distribution. Your ACB will be $9 ($10 – $1 = $9). If you sell the shares for $10, you will have to declare a capital gain of $1 per unit, even though you didn’t actually make a profit on the sale. Half of that $1 will be taxable.
Rental income. If you own a rental property, you are allowed to claim a number of expenses in calculating the net rental income for tax purposes. These include maintenance costs, utilities (if you pay for them), mortgage interest, property taxes, and more. See the CCRA Rental Income Tax Guide for complete details. You can download a copy at www.ccra-adrc.gc.ca/E/pub/tg/t4036/t4036eq.html