U.S. President Joe Biden has proposed changes to the tax laws that could significantly impact the portfolio of many wealthy investors. The changes aim to get the wealthy to pay more tax. While there are many elements to the tax proposal, we will discuss the proposed changes to the capital gains tax (CGT). We will also discuss how the new rules could impact U.S. people living in Canada and Canadians living in the United States.
What is a capital gain/loss?
Be it the United States or Canada, the definition of capital gain is the same; the cost of the asset, including other expenses (like commission or improvements) minus depreciation. This cost forms the basis of calculating capital gain, which is unrealized till you own the asset and is realized when you sell it.
In both countries, the capital gain is not adjusted for inflation. For instance, if you bought a house for $300,000 20 years back and sold it for $500,000 today, your capital gain is $200,000 irrespective of inflation. There doesn’t need to be always a capital gain. You may also face a capital loss. In such a scenario, you can use the capital loss to offset a capital gain.
While the definition of capital gain is the same, the tax treatment of this gain is different in the United States and Canada.
How is capital gains tax calculated in the United States and Canada?
In the United States, a long-term capital gain (when you sell the asset in less than a year) is taxed slightly lower than ordinary income. In 2021, the highest capital gains tax rate is 20% for single households with taxable income above US$445,850. This tax is charged only on realized capital gains, which means when you sell the asset. If you inherit assets, then the cost basis increases to the fair value of the asset at the time you inherit it (step-up in basis). If you sell the asset at the same fair value, your capital gain is zero.
In Canada, there is no separate rate for capital gains tax. You add 50% of the realized capital gain to your income and pay the income tax rate that applies. The additional tax would vary depending on how much income you generated from regular and other sources.
But Biden’s tax proposal aims to change this calculation and collect more money in capital gains tax (CGT).
Impact of Biden’s proposal on U.S. people living in Canada
Biden has proposed to almost double the top capital gains tax rate to 39.6% on gains over US$1 million. Moreover, he has proposed to remove the “step-up in basis” and charge heirs who inherit assets a CGT on the unrealized capital gain. The new CGT would apply to worldwide assets of U.S. people. This means, if you are a U.S. person living in Canada and have a house there, your heir will be subject to the U.S. CGT on the Canadian house.
For instance, Bob, a U.S. citizen, started a business in Canada for US$400,000 10 years back. He transferred the business to his daughter Mary, who is also a U.S. citizen. The present value of the company is US$1,450,000. However, under the current capital gain tax, Mary won’t bear any CGT as her cost basis has stepped up to US$1,450,000.
But under Biden’s tax proposal, Mary would face a 39.6% CGT on US$50,000 unrealized capital gain above US$1 million. Her CGT bill would come to $19,800.
Impact of Biden’s proposal on Canadian people having assets in the United States
And it is not just the U.S. people but also Canadians who have assets in the United States that would be subjected to the new capital gain tax. For instance, Sarah invested US$100,000 in U.S. tech stocks 15 years back through her Canadian Demat account. Her investment has surged 40 times, and the current value of her securities is US$4 million. On her death, her heir Joe gets these stocks.
Under Biden’s proposed rules, any gain above US$1 million would be subject to new CGT. Hence, Joe would face a 39.6% CGT on US$2.9 million (US$4 million – (US$1 million + US$100,000)) capital gain, plus a net investment income tax of 3.8%. Thus, his tax bill will come to US$1.25 million.
Many confuse that Biden is only targeting the super-rich with his 39.6% capital gain tax. But repealing of step-up in basis would bring a larger population under the CGT ambit. The new tax proposals are in discussion and are yet to be approved by Congress. But it is better to be prepared for any changes.
Contact Sloan Partners LLP for Tax Advice
At Sloan Partners LLP, our financial professionals will help ensure your company’s compliance while minimizing your tax obligations in Canada and beyond. Contact us online or by telephone at 416-665-7735.