Why Crystallize Capital Gains? What are the benefits?
Neufeld Legal PC: Chris@NeufeldLegal.com - 403-400-4092 / 905-616-8864
Crystallizing capital gains means deliberately triggering a capital gain for tax purposes, even if you do not intend to sell the underlying asset on the open market. While it seems counterintuitive to pay tax earlier, it's a powerful tax planning strategy in Canada with several significant benefits, which can include:
1. Utilizing the Lifetime Capital Gains Exemption (LCGE)
This is arguably the most common and compelling reason for crystallization. If you own shares of a Qualified Small Business Corporation (QSBC), or qualified farm or fishing property, you have a lifetime capital gains exemption (LCGE). As of 2024, the LCGE for QSBC shares is around $1 million (indexed annually).
Your QSBC shares might have appreciated significantly over time, but you might not be ready to sell your business. However, you might want to "lock in" the ability to use your LCGE now. This is because the criteria for QSBC status are strict and can change. For example, if your corporation accumulates too much passive property, it might lose its QSBC status in the future, rendering your shares ineligible for the exemption. The Benefit: By crystallizing the gain (often using a Section 85 rollover), you trigger a capital gain on your personal tax return. This gain can then be fully or partially offset by your available LCGE, resulting in a tax-free gain. The shares in the corporation or a new holding corporation now have a stepped-up Adjusted Cost Base (ACB), meaning that when you eventually sell the business, the future capital gain will be reduced by the amount you crystallized, or potentially eliminated if you used your full LCGE.
2. Taking Advantage of Lower Income Years Tax Rate Optimization:
If you anticipate a year where your personal income will be significantly lower than usual (e.g., due to retirement, parental leave, a sabbatical, or temporary unemployment), you might strategically crystallize a capital gain in that year.
By realizing the gain in a low-income year, the taxable portion of the capital gain will be added to your lower income, potentially being taxed at a much lower marginal tax rate than it would be in a higher-income year in the future. This allows you to pay less tax overall on the gain.
3. Offsetting Capital Losses Loss Utilization:
If you have accumulated capital losses from previous years (Net Capital Losses) that you're carrying forward, or you expect to realize other capital losses in the current year, you can crystallize a capital gain to offset these losses.
Capital losses can generally only be used to offset capital gains. By strategically realizing a gain, you create taxable income against which your losses can be applied, effectively reducing or eliminating your current taxable capital gain, and thus your tax liability. This prevents your valuable capital losses from expiring or being underutilized.
4. Anticipating Changes in Tax Law (e.g., Capital Gains Inclusion Rate) Pre-emptive Action:
When governments announce or propose changes to capital gains tax rules that would make them less favorable (e.g., an increase in the capital gains inclusion rate, as Canada recently experienced for gains over $250,000 for individuals and for corporations/trusts entirely), taxpayers often rush to crystallize gains before the new rules come into effect.
By crystallizing before the changes, you "lock in" the old, more favorable inclusion rate. This directly reduces the amount of tax you'll pay on that specific gain, as a smaller portion of the gain is included in your taxable income. This was a significant driver for many crystallization strategies leading up to June 25, 2024, in Canada; although the federal government subsequently revoked this increase to the inclusion rate.
5. Estate and Succession Planning Stepping Up Basis for Heirs:
Crystallizing gains can reset the ACB of assets for future generations. If you intend to pass appreciated assets (like shares of a family business) to your children or other heirs, crystallizing the gain now can increase the ACB for the future recipient.
When the heirs eventually sell the asset, their capital gain will be calculated based on the new, higher ACB, significantly reducing or eliminating their future capital gains tax liability. This facilitates a smoother, more tax-efficient intergenerational transfer of wealth.
Utilizing Exemptions Before Death: Death triggers a deemed disposition of all capital property at fair market value. Crystallizing gains before death allows you to proactively use your LCGE or offset losses, rather than potentially losing the opportunity if the assets don't qualify at the time of death, or if the LCGE cannot be fully utilized by your estate.
6. De-risking and Locking in Value Market Volatility:
For highly appreciated assets, especially in volatile markets, crystallizing a gain can "lock in" that profit. While you might continue to hold the asset, you've realized the gain for tax purposes, protecting it from a potential future downturn in market value.
This provides financial certainty regarding the tax implications of that gain, even if the asset's value subsequently drops.
Nevertheless, with this considerable discussion as to benefits that might be attained through the crystallization of capital gains, there are also some important caveats that need to be considered, including:
-
Cash Flow: Crystallizing a gain means paying tax now, even if you haven't received cash from a sale. You must have the liquidity to cover the tax liability.
-
Costs: There are professional fees (tax accountants, lawyers, valuators) involved in properly executing a crystallization strategy.
-
Complexity: Crystallization strategies are highly complex and require careful planning and execution to ensure compliance with tax laws and to avoid unintended consequences (e.g., attribution rules, general anti-avoidance rule (GAAR)).
-
Superficial Loss Rules: You cannot simply sell an asset at a loss and immediately repurchase it to trigger a capital loss. Canadian tax rules have "superficial loss" provisions to prevent this. Crystallization for gains typically involves specific types of transfers (like Section 85 rollovers to a corporation or transfers to a trust/spouse with an election).
Significance of Professional Advice: As with most tax planning strategies, crystallizing capital gains is a complex technical process, which requires the application of strict rules to the particular facts and circumstances. It is highly recommended to seek advice from a tax accountant and a lawyer to ensure compliance and to properly structure the transaction for your specific circumstances.
For knowledgeable and experienced tax law representation for crystallizing capital gains and other tax planning strategies, contact tax lawyer Christopher R. Neufeld at Chris@NeufeldLegal.com or call 403-400-4092 (Calgary, Alberta) / 905-616-8864 (Toronto, Ontario).
|
Can I Rollover My Cryptocurrency Account into a
Corporation? |
|
Why would I use a Section 85 Rollover? What are the benefits? |
|
Why use a
Rollover when Incorporating a Sole Proprietorship |
|
Why
Crystallize Capital Gains? What are the benefits? |
NOT LEGAL ADVICE. Information made available on this website in any form is for information purposes only. It is not, and should not be taken as legal advice or tax advice. You should not rely upon, or take or fail to take any action, based upon this information. Never disregard professional legal advice or delay in seeking legal advice because of something you have read on this website. The law firm of Neufeld Legal PC would be pleased to discuss legal matters referenced in this website upon their retention in accordance with applicable requirements pertaining to client retention by this law firm. Thank you.