When Taxes And Inflation Erode The Value Of Your Cottage

This tax, which has existed since 1972, is widely seen as having a negative effect on entrepreneurship.

06/28/2017 17:26 EDT | Updated 08/02/2017 14:59 EDT
jnnault via Getty Images

Millennials are increasingly attracted by the idea of buying a cottage. According to a poll carried out by Léger for RE/MAX, 65 per cent of them would like to do so in the next 10 years. Without wanting to discourage them, I wonder if they are aware that the taxation of their potential capital gains could make this adventure much less interesting.

Just imagine: A Quebec resident who had paid $50,000 for a cottage in 1980 and sells it now for $250,000, and who is now in the top income tax bracket, will have to pay $53,000 on his $200,000 of capital gains.

This is because in Canada, 50 per cent of capital gains are added to taxable income for the year in question. For a taxpayer in the top tax bracket, with a marginal rate of around 53 per cent of gross income (in Quebec), this means a net capital gains tax rate of 26.5 per cent.

If you think this is unfair, you're probably right. This tax, which has existed since 1972, is widely seen as a tax that has a negative effect on entrepreneurship. Even worse: In Canada, when the capital gains tax is imposed, the government does not take inflation into account in calculating the amount paid for the asset, which means that the real tax rate is even higher!

The prices of goods and services increase over time, among other things because the quantity of money in circulation increases, which means that each unit of money loses some of its value each year. This is what is known as inflation.

In the cottage example above, the seller has to pay $53,000 on his capital gains, while he "invested" $50,000 at the outset. However, according to the Bank of Canada's Inflation Calculator, a basket of goods costing $50,000 in 1980 would cost $150,300 in 2017. A large portion of his "profit" is therefore simply the result of inflation over the years. The real capital gain for the seller is thus not $200,000, but rather $99,700 ($250,000 - $150,300).

In other words, even though he sells his cottage for $250,000, our seller is not necessarily much "richer," since everything around him, everything he consumes, is also more expensive.

But currently, the government taxes the nominal gain (including inflation) and not the real gain. The real tax rate is therefore not 26.5 per cent, but much higher in the case of investments that were made a long time ago.

Stephen Jarislowsky, a very successful Canadian entrepreneur, recently explained the problem in the Financial Post. He is not alone. In Quebec, the Godbout Commission recommended among other things that inflation be taken into account in taxing capital gains.

Some governments have already moved in this direction. In Israel, a country that has experienced episodes of high inflation, the capital gains tax applies to the total amount of the real gain, not to the amount of the nominal gain like in Canada. The tax is therefore applied to appreciation, minus the cost of inflation.

Same thing when an individual sells shares. If the seller holds less than 10 per cent of the company, the tax is 25 per cent; if he holds more than 10 per cent of the company, the rate goes up to 30 per cent. But in either case, the tax is applied on the real amount of the gain, and not on the nominal amount (that is to say, inflation is deducted).

As Mr. Jarislowsky pointed out in his article, taking inflation into account in calculating the taxation of capital gains would be very simple now thanks to the high-performance computers and software that we already use to prepare our income tax returns.

Income tax has to be fair. It should therefore not unjustly penalize investments by ignoring the effect of inflation.

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