Module 6: Capital gains and losses - PD Net

Course Schedule Course Modules Review and Practice Exam Preparation Resources 

Module 6: Capital gains and losses 

Overview 

Taxable capital gains and allowable losses are included in income under paragraph 3(b). However, the detailed 

rules governing capital gains and losses are found in subdivision c of Division B of the ITA, which encompasses 

sections 38 to 55. The rules for calculating capital gains or losses are numerous and sometimes complex. You 

will not study all the rules for the purposes of this course. You will learn the most significant aspects of the tax 

treatment of capital gains and losses. 

First, you will study why capital gains are subject to a preferential tax treatment. Then, you will study the basic 

concepts and rules for the recognition and computation of capital gains and losses. You will learn that in order 

to reduce or defer income tax, taxpayers may sometimes defer taxation of capital gains by establishing a 

capital gains reserve where proceeds of disposition are not due until a future year. 

Next, you will see that the tax treatment of capital gains and losses is also influenced by the nature of the 

property in question and that there are many restrictions on the deduction of capital losses. 

You will also examine special rules, such as those relating to a principal residence, changes in use of a 

property, and replacement property. 

This module concludes with a computer illustration that incorporates the topics covered in the lesson. 

Test your knowledge 

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the 

depth of study required. 

Module 6 

6.1 Introduction to capital gains 

6.2 Capital property and disposition 

6.3 General rules for determining taxable capital gains and allowable capital losses 

6.4 Specific provisions for capital gains and losses 

6.5 Special rules: Principal residence exemption, change in use, and replacement property 

6.6 Computer illustration 6.6-1: Determining capital gains and losses 

Learning objectives 

6.1 Explain why capital gains and losses are treated differently from other types of income. (Level 1) 

6.2 Describe what types of property and what circumstances give rise to capital gains or losses. (Level 1) 

6.3 Calculate taxable capital gains, allowable capital losses, and the allowable capital gains reserve. (Level 1) 

6.4 Describe specific rules that apply in the calculation of capital gains and losses, including the treatment for 

identical properties and depreciable property, and the restrictions on the deduction of capital losses for 

personal-use property, listed personal property, superficial losses, and business investment losses. (Levels 1 

and 2) 

6.5 Explain the special rules for the principal residence exemption, changes in use, and replacement property. 

(Level 2) 

6.6 Use Cantax to calculate and report capital gains or losses on disposition of capital properties. (Level 1) 

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Assignment reminder: 

Assignment #2 (see Module 7) is due at the end of week 7 (see Course Schedule). You may wish to take a 

look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in 

advance. 

Module summary 

Print this module 

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6.1 Introduction to capital gains 

Learning objective 

Explain why capital gains and losses are treated differently from other types of income. (Level 1) 

Required reading 

LEVEL 1 

Text: 7,010; 8,020 to 8,035 (Level 1) 

ITA: 3 (Level 1) 

Historically, capital gains were not subject to Canadian income tax because they were not considered as 

income under the "source" theory (section 4 of the ITA). Under this theory, income can only originate from a 

productive source. The metaphor of the fruit and the tree is used to illustrate the source theory: income 

represents the fruit and capital represents the tree. Any gain realized on the disposition of the tree is capital 

since only the fruit is income. 

Under the 1971 tax reform, starting in 1972, only one-half of capital gains were included in income for tax 

purposes. The required reading covers the history of the inclusion rates for capital gains and the legislative 

intent behind the taxation of capital gains. The source theory was not abandoned with the 1971 tax reform as 

is illustrated by the structure of sections 3 and 4 of the ITA. Income from a source is included in income for 

tax purposes under paragraph 3(a), while capital gains are included under paragraph 3(b). Capital gains are 

subject to a different tax treatment that is generally more favourable than the treatment of source income; 

accordingly, they are dealt with separately. 

Capital gains receive preferential treatment in the following respects: 

Only one-half of the gains are included in income. 

The taxable capital gain is equal to zero when certain capital property is gifted to a charity or 

other qualified donee (applicable after May 1, 2006). 

The taxable capital gain is equal to zero when certain securities are gifted to a private foundation 

(applicable after March 19, 2007). 

The taxable capital gain is equal to zero when certain exchangeable shares are gifted to a charity 

or other qualified donee (applicable after February 26, 2008). 

Gains are included in income only when they are realized, not on an accrual basis (the realization 

principle). 

The gain on the disposition of a principal residence may be exempted from tax. 

For individuals, the gain on the disposition of shares of a small business corporation, farm 

property, or fishing property may be exempted from tax up to a maximum of $750,000 (taxable 

portion $375,000). 

Capital losses are subject to numerous restrictions: 

When capital losses are deductible, they are generally only deductible against capital gains. 

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Capital losses on personal-use properties are not deductible or, in the case of listed personal 

properties, can only be claimed against capital gains realized on other listed personal properties. 

Capital losses on some transactions specified in the ITA are not deductible, or their deductibility is 

deferred until a specific event occurs. 

The reasons justifying the special treatment of capital gains may be summarized as follows: 

The preferential treatment of capital gains promotes investment, particularly in risky ventures, by 

giving the investor a potentially higher yield on investment. 

The gain realized on property that is held for some years is caused mainly by inflation. To adjust 

the gain to take into account the inflation component would be very complex. It is better, in 

terms of certainty and simplicity, to have a universal rule such as the one-half inclusion rule. 

However, this general rule applies whether property is held for many years or only for a few 

months. In the case of short-term capital gains, the reduced rate of inclusion causes inequity 

between taxpayers who realize capital gains that are only one-half taxable and taxpayers who 

earn other types of income. 

Capital gains are taxed when realized, and not on an accrual basis. This is because of the 

difficulty that taxpayers, as well as the tax authorities, would have in valuing all capital properties 

annually in order to determine accrued capital gains. Also, taxing capital gains on an accrual basis 

could create financial problems for taxpayers who would have to pay taxes when they have not 

yet cashed in their gains. However, the taxation of capital gains when realized means that the 

accumulated gain is taxed in the year of disposition and may be taxed at a higher marginal tax 

rate for individuals than it would have been taxed if recognized as it accrued. 

The principal residence exemption stems from a presumption that no real economic gain is 

realized when a home is sold and another is purchased. While this could apply to capital gains on 

other personal-use property, the government has chosen to exempt gains on a taxpayer's 

principal residence only. But even when a new home is not purchased and there is no economic 

reason not to tax the gain as any other gain, it is a widely-accepted proposition that the gain 

from the sale of a home should not be taxed. The idea that home ownership must be supported 

because it promotes community stability is the basis for this principle. 

The capital gains deduction (section 110.6) on small business corporation shares, farm property 

or fishing property was introduced to encourage entrepreneurial risk taking and to 

support investments in these businesses by Canadians. 

Over the years, these reasons were often criticized on the basis that the preferential treatment infringes on 

horizontal and vertical equity. Horizontal equity requires taxpayers who have similar economic power to bear 

the same tax burden. From an economic point of view, there is no reason for a different tax treatment of a 

dollar earned as salary and a dollar derived from a capital gain. 

Vertical equity requires that taxpayers who have a higher ability to pay tax are taxed more than those with a 

lower ability to pay. Since mostly high-income taxpayers derive capital gains, they are the ones who benefit 

from the preferential treatment of capital gains, and thus, vertical equity is affected. 

The preferential treatment is also criticized on the grounds that it invites tax avoidance schemes. Taxpayers 

may try to devise transactions to transform income from a source into capital gains. Complex anti-avoidance 

rules are therefore needed. This adds to the complexity of the ITA and imposes administrative costs to the 

government to ensure compliance with these rules. These costs are supported by all taxpayers and not only by 

those involved in the transactions under scrutiny. 

It has also been suggested that the preferential treatment of capital gains may be a disincentive to use 

resources in the most productive way. Since capital gains are taxed only when realized, taxpayers can control 

the timing of the recognition of these gains. Taxpayers may be reluctant to sell property and pay tax when 


substantial gains have accrued on the property, even though more productive investments are available. 

As you can see, the tax treatment of capital gains is controversial. The government has chosen to consider 

capital gains and losses as a special type of income for tax purposes for the reasons outlined earlier. Whether 

or not these reasons are valid in the present context is subject to debate. Nonetheless, taxpayers have to 

abide by the rules contained in the ITA. 

The tax treatment of capital gains is also complex because, for policy reasons, the tax rules vary, depending on 

the type of capital property that is disposed. Keeping in mind the preceding comments on the tax policy behind 

the ITA rules concerning capital gains and losses, you will now study these rules. 



6.2 Capital property and disposition 


Describe what types of property and what circumstances give rise to capital gains or losses. 

(Level 1) 


Optional reading 

LEVEL 1 

Text: 7,012; 7,018; 7,020 (Level 1) 

Text: 7,040 (Level 2) 

ITA: 39(1)(a), 40(1)(a) (Level 1) 

ITA: 39(4), 39(5), 39(6) (Level 2) 

ITA: Definitions, 54: adjusted cost base, capital property, listed personal property, personal-use 

property, proceeds of disposition (Level 1) 

ITA: Definitions, 248(1): disposition (Level 1) 

IT: 460 

Capital property — introduction 

Capital gains and losses can only be realized on capital property. In determining what is a capital property, the 

definition in section 54 of the ITA is not really helpful. The definition provided for in section 54 states that 

capital property means: 

depreciable property 

or 

non-depreciable property, the disposal of which gives rise to a capital gain or loss 

Some indication is given in the ITA as to what is not a capital property, since no capital gains or losses can be 

realized on the following types of properties, as provided for in paragraph 39(1)(a): 

eligible capital properties 

certain cultural properties 

Canadian and foreign resource properties 

insurance policies 

timber resource properties 

interest of a beneficiary under a qualifying environmental trust 

Except for these references, the ITA provides little guidance in determining if a given property is capital 

property, the disposition of which will give rise to a capital gain or loss, or if the property is inventory, the 

disposition of which will give rise to business income or loss. One must turn to the case law to find the main 

criteria for distinguishing capital gains from business income. 

The annual volume of reported tax cases on the issue of capital gains versus business income leads one to 

conclude that the tax objective of certainty has not been achieved in respect of distinguishing capital property 

from other types of property. While uncertainty undoubtedly plays a part in the number of court cases, 


taxpayer motivation is also a factor. Taxpayers generally prefer capital gains with a 50% inclusion rate 

compared to other types of income included at 100%. 

Disposition 

Capital gains and losses are not taxed on an accrual basis. As the tax on the gain is deferred until the gain is 

realized, a tax preference occurs, allowing taxpayers to take advantage of the time value of money. This 

realization rule has its downside since, in the year the gain is realized, there is a "bunching up" in income, of 

past years' accrued gains. Therefore, the gain may be taxed at a higher rate of tax than if the accrued gains 

had been taxed on a yearly basis. 

An advantage of the realization basis is that it allows taxpayers to control the timing of the gain. For example, 

taxpayers may decide to sell capital property on which a substantial gain has accrued in a taxation year in 

which they incur losses in order to reduce the tax liability on the gain. 

The realization basis is introduced in the ITA by providing that capital gains are taxed when a "disposition" 

occurs, as confirmed by the opening words of paragraph 40(1)(a). Therefore, it is very important to have a 

good knowledge of what constitutes a disposition in order to be able to recognize when a capital gain becomes 

taxable and, if possible, to control the timing of the taxation of the capital gain. 

To understand the extent of the first item in the definition of "disposition" in section 248(1), you must review 

the definition of "proceeds of disposition" in section 54. It then becomes clear that a disposition includes not 

only voluntary dispositions, such as a sale of property, but also involuntary dispositions such as its 

expropriation, damage, destruction, or loss when the taxpayer receives compensation. A disposition can also 

occur when a creditor takes a property in payment of a debt. 

The definition in section 54 is not exhaustive (note the use of the word "includes" in the definition), which 

means that a disposition may occur in situations not mentioned, such as when property is destroyed and there 

is no compensation. In order to prevent the indefinite postponement of the taxation of capital gains, several 

provisions of the ITA deem a disposition to occur if a specified event occurs, even though the property is not 

really disposed. Section 7,020 of the text provides some examples of deemed dispositions for tax purposes 

along with the corresponding ITA provision. 



6.3 General rules for determining taxable capital gains and 

allowable capital losses 


Calculate taxable capital gains, allowable capital losses, and the allowable capital gains reserve. 

(Level 1) 


LEVEL 1 

Text: 7,110 to 7,125; 8,110; 8,130 (Level 1) 

Text: 7,910 (Level 3) 

ITA: 3, 38, 39, 40(1), (1.1), 40(2)(a), 53(1)(j), 53(2)(k) (Level 1) 

ITA: Definitions, 248(1): allowable capital loss, capital gain, capital loss, taxable capital gain 

(Level 1) 

ITAR: 20(1), 26(3) (Level 2) 

Capital gains and losses: General formula 

When you have determined that a disposition of a capital property has occurred, you must compute the taxable 

capital gain or the allowable capital loss. First determine the gain or loss in accordance with subsection 40(1), 

then follow section 39 to characterize the gain or loss amount as a capital gain, capital loss, or business 

investment loss, if none of the restrictions apply. For example, you cannot have a capital gain or capital loss on 

the disposition of eligible capital property nor can you have a capital loss on depreciable property. You then 

determine the taxable capital gain or allowable capital loss in accordance with section 38, applying the relevant 

inclusion rate. Only a fraction (1/2 for 2010) of the capital gain or loss is taxable or allowable. 

These qualifiers (taxable capital gain, allowable capital loss) are very important because they refer to the 

amount of capital gain that is included when computing income or the amount of capital loss that may be 

deducted in calculating income under paragraph 3(b). Pay close attention to these qualifiers so you fully 

understand their significance. A reference to a capital gain is quite different from a reference to a taxable 

capital gain. Similarly, a capital loss is different from an allowable capital loss. 

Adjusted cost base 

The additions and deductions to the cost base of non-depreciable property under section 53 are intended to 

prevent double taxation. Additions to the cost base are usually amounts paid that were not deductible, or 

amounts received that have already been taxed or were not taxable. For example, when employees acquire 

shares of a corporation under a stock option plan and a benefit is included in their employment income under 

section 7, the amount of the benefit is added to the adjusted cost base (ACB) of the shares acquired 

[paragraph 53(1)(j)]. Another example is the subsection 18(2) denial of interest and property taxes as a 

business expense on vacant land. Paragraph 53(1)(h) allows the amount denied under subsection 18(2) to be 

added to the ACB. 

Deductions are often amounts received on a tax-free basis. For example, when a taxpayer acquires a property 

and receives a government subsidy for the acquisition of this property, the ACB of the property will be the price 

paid less the amount received as a subsidy [paragraph 53(2)(k)]. Many adjustments under subsections 53(1) 

and (2) are very technical and will not be studied in this course; however, the majority of capital transactions 

require no adjustments under subsections 53(1) or (2) in determining the ACB of the disposed property. 


Disposition costs 

When capital property is sold, various costs can be incurred for the purpose of selling the property and as a 

result of its sale. These amounts, along with the ACB of the property, are deducted from the proceeds of 

disposition (POD) in calculating the gain or loss [subparagraph 40(1)(a)(i)]. There is no definition of disposition 

costs in the ITA. If these costs are not otherwise deductible in computing income and are incurred for the 

disposition of the property, the items are deducted from the POD to calculate the gain or loss. 

Example 

Guylaine Doyon disposed of a non-depreciable capital property that was used to earn business income. That 

property was disposed of for $10,000. The selling costs totalled $500 and the original cost of the property for 

Guylaine was $4,000. 

POD $10,000 

Less: Cost of property $4,000 

Selling expenses 500 (4,500) 

Gain $5,500 

As the property disposed of was a non-depreciable capital property, the amount of the gain under section 40 is 

equal to the capital gain under section 39. 

Activity 6.3-1 — Taxable capital gains 

In this activity, you calculate the taxable capital gain for a non-depreciable capital property. 

LEVEL 3 

Cost of assets owned on December 31, 1971 

The rules for calculating capital gains for property held on December 31, 1971 differ depending on whether or 

not the capital property in question is depreciable. On disposition of a depreciable capital property acquired 

before 1972, the median rule does not apply. Instead, under ITAR 20(1), if the capital cost of the depreciable 

property is less than both the FMV on valuation-day (V-day) and the POD, the POD is deemed to be the total 

of the capital cost of the property and the POD less FMV on V-day. The capital gain is therefore calculated 

using the deemed POD. 

LEVEL 1 

Gains reserve 

For individuals, the prescribed Form T2017, Summary of Reserves on Dispositions of Capital Property, must be 

filed to claim a capital gains reserve. The (b) portion for the reserve formula may be restated as: 

in the year of disposition: 

first year after disposition: 

second year after disposition: 

third year after disposition: 

fourth year after disposition: 

4/5 of the capital gain 




nil 

Thus, whatever the unpaid balance of the selling price, at least one-fifth of the capital gain must be recognized 

in each year the reserve is claimed on a cumulative basis. 


You may recall another reserve under paragraph 20(1)(n), which you studied in the calculation of business 

income (Topic 3.4). Do not confuse the reserve for proceeds outstanding for business income with the 

section 40 reserve where you are calculating a gain. This distinction highlights for you the importance of 

understanding what type of property you are dealing with to determine the correct tax consequences. 

Activity 6.3-2 — Taxable capital gains reserves 

In this activity, you calculate the capital gains reserve for a property. 

Donations of capital property 

Where a taxpayer directly gifts certain capital properties to a registered charity or other qualified donee [as 

defined in subsection 149.1(1)], the taxable capital gain is zero per paragraphs 38(a.1) and (a.2). Where a 

taxpayer directly gifts certain securities to a private foundation, the taxable capital gain is also zero per 

paragraphs 38(a.1) for gifts subsequent to March 18th, 2007. Finally, where a taxpayer directly gifts certain 

exchangeable securities to charity or other qualified donee, the taxable capital gain is zero under certain 

conditions (for gifts subsequent to February 25, 2008). 

Investments that are eligible for this tax treatment include shares, bonds, bills, warrants, futures, and 

exchangeable shares. Mutual funds may also qualify. This will only benefit a taxpayer when the donation of the 

capital property is made directly to the qualified donee. If the capital property is sold and the proceeds donated 

to the donee, the zero inclusion rate will not apply. If there is no accrued gain on the capital property, donating 

shares will have the same result as donating cash. 



6.4 Specific provisions for capital gains and losses 


Describe specific rules that apply in the calculation of capital gains and losses, including the 

treatment for identical properties and depreciable property, and the restrictions on the deduction 

of capital losses for personal-use property, listed personal property, superficial losses, and 

business investment losses. (Levels 1 and 2) 



LEVEL 1 

Text: 7,210 to 7,220; 7,270 to 7,285; 7,710; 8,200; 8,300 (Level 1) 

ITA: 3(b), 39(1)(b), 41(1) and (2), 46(1), 47(1), 111(1)(b) (Level 1) 

ITA: Definitions, 111(8): net capital loss (Level 1) 

Text: 7,330 to 7,340; 7,710 (review); 7,720 (Level 2) 

ITA: 3(d), 38(c), 39(1)(c), 40(2)(g), 50(1), 53(1)(f) (Level 2) 

ITA: Definitions, 54: superficial loss (Level 2) 

ITA Definitions, 248(1): small business corporation (Level 2) 

IT: 387R2 (Consolidated), 484R2 

Personal-use property and listed personal property 

In order to achieve neutrality, the tax system should not differentiate between business and investment 

decisions. Whether a taxpayer invests his discretionary savings in common shares, a boat, or a piece of art, tax 

rules should not favour certain types of investments. If gains on personal-use property (PUP) and listed 

personal property (LPP) were not taxed, taxpayers who choose to invest in income-producing property would 

be penalized, while individuals who invest in personal property could end up with a tax-free increase in wealth. 

A broader tax base for the taxation of capital gains supports the neutrality objective. The overall intent of the 

taxation of capital gains is to tax economic income, regardless of the type of property held. 

The text refers to a minimum amount of $1,000 as the deemed cost and proceeds of disposition applicable to 

personal-use property, including listed personal property dispositions. This is known as the de minimus rule. 

Example 1 

Jody Wyatt bought a used motorcycle for $1,800. What is her taxable capital gain if she sells it for 

Solution 

a. $500 

b. $2,000 

Under the ITA, the calculation of both the gain (called a "net gain") and the taxable portion of the net gain 

(called a "taxable net gain") for listed personal property are found in subsections 41(2) and 41(1) respectively, 

rather than in sections 39 and 38. 

Note that clause 3(b)(i)(B) brings the taxable net gains from LPP for the year into income separately from 

taxable capital gains from the disposition of other property. Other allowable capital losses can be used to 


offset these taxable net gains from LPP. 

The carryback and forward provision is also found in subsection 41(2), and is part of the calculation of the "net 

gain" from LPP for the year, and thus in income for the year. This is different from net capital losses, whose 

carryback and forward provision is found in subsection 111(1), and occurs in the calculation of taxable income. 

The government allows the limited deduction of capital losses on LPP because it recognizes that they may have 

some economic value. 

Example 2 

Moira Levesque sold the following items: 

Sales price 

Cost 

Painting $ 3,000 $ 900 

Set of stamps 1,500 1,200 

Diamond ring 2,000 3,500 

Assuming there were no disposition costs related to any of these transactions, determine Moira’s tax 

consequences. 

Solution 

General limitations on capital losses 

Capital gains are subject to preferential treatment, but as a counterpart, capital losses are subject to many 

restrictions. Some of these restrictions are of a general nature, while others are related to specific transactions 

or categories of property. 

The general rule concerning the deductibility of allowable capital losses is that they can only be deducted 

against taxable capital gains [paragraph 3(b)]. If allowable capital losses for a year exceed the taxable capital 

gains for the year, the net capital losses may be carried back three years and forward indefinitely to offset the 

excess of taxable capital gains over allowable capital losses for those years [paragraph 111(1)(b) and 

subsection 111(8), "net capital loss"]. This is done in the calculation of taxable income, not income (in other 

words, net income). 

The basic reason why allowable capital losses are not deductible against other sources of income is that the 

realization basis of capital gains taxation enables taxpayers to choose the timing of the realization of capital 

gains or losses. The restriction on the deductibility of capital losses is intended to limit planning opportunities 

that would allow taxpayers to dispose of capital property at a loss to reduce their income, while continuing to 

hold other capital property on which capital gains have accrued. 

Identical properties 

Taxpayers will often purchase identical properties (for example, the same security or the same bond) at 

different times and for different prices and sell them at different times for different prices. The ITA does not 

define an "identical property." To be identical, the properties must be identical in all respects. So, two common 

shares in the Bank of Nova Scotia are identical properties. But a common share is not identical with a class A 

share (even if it is a common class A share), nor with a preferred or special share. Two townhouses are not 

identical properties, even though they are in the same complex. 

Depreciable property 

Capital losses may never be claimed in respect of depreciable property [39(1)(b)(i)]. Because such property 

depreciates over time, any decline in value is deemed to be normal depreciation and is therefore not 

considered to be a capital loss. Furthermore, if this type of property is sold for less than its capital cost, the 

rules on capital cost allowance will apply to recognize a terminal loss, recapture of capital cost allowance, or to 

reduce the UCC of the class in which the property was included. To claim a capital loss would in fact be double 


counting. 

LEVEL 2 

Superficial losses 

Taxpayers with realized substantial capital gains in a taxation year may wish to recognize capital losses on 

other property that they do not really want to dispose of, by selling and repurchasing the same property in a 

very short period of time. To address the situation where the disposition is solely tax-motivated (deduction of 

the loss), the rules on superficial losses prevent the recognition of a loss when the taxpayer has not actually 

given up equity in the property. 

A superficial loss is one realized by a taxpayer, where an identical property (referred to as “substituted 

property”) is acquired or reacquired by either the taxpayer or an affiliated person (for example, a spouse) within 

30 days before and 30 days after the disposition. At the end of that period the taxpayer or affiliated person still 

owns a portion of the substituted property. The superficial loss that is denied is added to the adjusted cost 

base of the property repurchased (that is, substituted property). 

Allowable business investment losses (ABILs) 

The legislative intent for the special treatment of ABILs is intended to promote investment in small and 

medium-sized business corporations in Canada, by reducing the after-tax risk of investing in these businesses. 

To have an ABIL there must first be a disposition (or deemed disposition of property) giving rise to a loss under 

subsection 40(1). The disposition of the capital property then must qualify as a business investment loss (BIL) 

under paragraph 39(1)(c). Finally, paragraph 38(c) creates the deductible or allowable portion. In the 

definition of a small business corporation (SBC), CRA interprets "all or substantially all" to mean 90% or more 

and "principally" to mean 50% or more. 

Where it is an actual disposition, the ITA requires that it be to an arm’s-length person. Often in the case of an 

SBC there is no market for the debt or shares and therefore no real disposition is possible. Section 50(1) allows 

a taxpayer to elect to be deemed to have disposed of the property. A deemed disposition occurs for POD of 

zero. The election can be made for any debt that is a bad debt, and for shares where the corporation is 

bankrupt or being wound-up; or is insolvent and no longer carries on business, and it is reasonable to expect 

that it will be wound-up or dissolved. Where an election under subsection 50(1) is made, the taxpayer is 

deemed to have reacquired the property at an ACB of nil. Therefore, any future recovery of the investment is a 

capital gain. 



Example 1 solution 

a. Sale for $500 

Deemed POD [46(1)] $ 1,000 

ACB (1,800) 

Loss $ (800) 

The $800 loss is deemed to be zero under subparagraph 40(2)(g)(iii). 

b. Sale for $2,000 

POD $ 2,000 

ACB (1,800) 

Gain $ 200 

Taxable capital gain (1/2) $ 100 

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Example 2 solution 

Painting 

POD $ 3,000 

Deemed ACB [46(1)] (1,000) 

Gain on disposition of LPP $ 2,000 

Set of stamps 

POD $ 1,500 

ACB (1,200) 

Gain on disposition of LPP $ 300 

Diamond ring 

POD $ 2,000 

ACB (3,500) 

Loss on disposition of LPP $ (1,500) 

Net gain on the disposition of listed personal property [41(2)] 

$2,000 + $300 – $1,500 = $800 

Taxable net gain on the disposition of listed personal property [41(1)] 

1/2 × $800 = $400 

The $400 is included in income under clause 3(b)(i)(B). 

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6.5 Special rules: Principal residence exemption, change in use, 

and replacement property 


Explain the special rules for the principal residence exemption, change in use, and replacement 

property. (Level 2) 



LEVEL 2 

Text: 7,230 to 7,255; 8,175; 8,210 (Level 2) 

ITA: 40(2)(b), 44(1), (5), (6), 45 (Level 2) 

Definitions, 54: principal residence 

Text: 8,180 (election for additional deferral) 

IT: 120R6 

Principal residence exemption 

Personal-use property includes a personal residence owned by a taxpayer, such as a home, condominium or 

cottage. While gains on personal-use property are taxable, paragraph 40(2)(b) provides an exemption for a 

taxpayer’s principal residence as outlined in the text. Capital losses on a principal residence are not allowed, as 

the property is a personal-use property. 

Prior to 1982, a taxpayer and spouse (and a child, if the child were an owner) could each designate a housing 

unit as a principal residence during the same period. This was especially attractive to taxpayers with a home 

and a cottage. However, after 1981, only one principal residence for each family unit can be designated for 

each year. Transitional rules [subsection 40(6)] still allow a family unit to designate two principal residences for 

years prior to 1982. Essentially, only gains since 1981 are included in income where a property is designated as 

a principal residence before 1982, but not after. The gain is based on the actual proceeds less the fair market 

value of the property at December 31, 1981. 

Change in use 

When taxpayers acquire property for their personal use and later on begin to use the property to earn income, 

or vice versa, they are deemed to have disposed of the property for POD equal to the FMV of the property at 

the time the change in use occurred [subsection 45(1)]. For example, there is a change of use if a taxpayer 

begins to rent out a house that was previously used for personal use. 

When the use of the property changes from personal to income producing, an election [subsection 45(2)] may 

be made to defer the deemed disposition. Under this election, the taxpayer is deemed not to have changed the 

use of the property until the election is rescinded. Therefore, the taxation of the taxable capital gain on the 

property may be deferred until the election is rescinded or the property sold, whichever occurs first. 

When the use of the property changes from income producing to personal, the election to defer the gain is 

only available if the property becomes a principal residence of the taxpayer [subsection 45(3)]. For either 

election to apply, the taxpayer must not have claimed any CCA on the property when it was used for income 

producing purposes [subsection 45(4)]. 


Replacement property 

Where a taxpayer realizes a capital gain on the involuntary disposition of a capital property or on the voluntary 

disposition of a former business property, the taxpayer may elect, in the year the property is replaced, to defer 

that gain. The gain may only be deferred to the extent that the taxpayer reinvests the proceeds of disposition 

in a replacement property within a certain time frame. 

The replacement property rules parallel the exchange of property rules for the disposition of depreciable 

property [subsection 13(4)]. Under subsection 44(5), to qualify for the deferral, a replacement property must 

meet these criteria: 

be put to the same or similar use, by the taxpayer or a related person, as the former property; 

and 

be used by the taxpayer or a related person in the same business or a similar business. 

Essentially, the taxpayer may elect to reduce the adjusted cost base of the replacement property to the extent 

of the capital gain, or part thereof, reinvested in the replacement property. Any excess of the proceeds of 

disposition over the replacement cost remains a capital gain. 

On the disposition of land and a building, the taxpayer may elect, in the year of replacement [subsection 44(6], 

to reallocate the excess proceeds of disposition between the components so that less capital gain or recapture 

will be reported. This is further explained in text section 8,040, which is optional reading and 

non-examinable. 



6.6 Computer illustration 6.6-1: Determining capital gains and 

losses 


LEVEL 1 

Use Cantax to calculate and report capital gains or losses on disposition of capital properties. 

(Level 1) 

This computer illustration applies the rules for capital gains and losses studied in this module. It outlines the 

tax consequences for an individual who owns various types of property that have been disposed of in the 

current taxation year. 

You will calculate the tax consequences manually, then use Cantax to complete the T1 return. Follow the steps 

carefully to ensure you understand the calculations of each of the different items. Refer to the explanations in 

the course material if you do not understand the suggested solution. 

Description 

This is a continuation of Paul Merlin's income tax return. Paul carried out the following transactions in 2009. 

1. On November 12, 2009, Paul disposed of the following common shares of public taxable 

corporations: 

Corporation 

Number of 

shares 

Date 

acquired 

Proceeds of 

disposition 

Adjusted 

cost base 

Selling 

expenses 

ABD Inc. 200 1995 $ 45,000 $ 30,000 $ 2,000 

DEF Inc. 400 1995 50,000 70,000 3,000 

KING Inc. 100 1999 40,000 200,000 2,000 

QUEEN Inc. 600 1996 300,000 220,000 — 

2. On January 15, 2009, Paul disposed of two houses in Vancouver that had been rental units 

since they were acquired on January 1, 1979. There was no rental income for 2009, as the 

properties were sold at the beginning of the year. 

Property 

Proceeds of 

disposition 

Adjusted 

cost base 

Selling 

expenses 

House 1 

Land $ 300,000 $ 200,000 $ 5,000 

Building 400,000 300,000 8,000 

House 2 

Land $ 180,000 $ 150,000 $ 2,000 

Building 150,000 170,000 3,000 

The houses were in the following CCA classes: 

Property UCC as at 

1/1/09 

Class 

House 1 — building $ 200,000 3 


House 2 — building 100,000 6 

3. Paul disposed of the following properties in January: 

Property 

Proceeds of 

disposition 

Adjusted 

cost base 

Selling 

expenses 

Family cars 

1 $ 15,000 $ 12,000 $ 500 

2 10,000 14,000 — 

Paintings 

1 30,000 2,000 1,500 

2 5,000 8,000 400 

Diamond ring 50,000 10,000 — 

Home computer 900 2,000 — 

Persian carpet 1,200 600 — 

There was no loss carryover on listed personal property at the beginning 

of 2009. 

Required 

Solution 

a. Determine Paul's tax consequences of his 2009 transactions. 

b. Use Cantax to calculate and report Paul's transactions for 2009. 



Computer illustration 6.6-1: Suggested solution 

Part (a): Tax consequences on disposition of property 

Shares 

POD 

ACB 

Selling 

expenses 

Capital gain 

(loss) 

ABD Inc. $ 45,000 $ 30,000 $ 2,000 $ 13,000 

DEF Inc. 50,000 70,000 3,000 (23,000) 

KING Inc. 40,000 200,000 2,000 (162,000) 

QUEEN Inc. 300,000 220,000 — 80,000 

Total $ 435,000 $ 520,000 $ 7,000 $ (92,000) 

Allowable capital loss (1/2) $ (46,000) 

Houses 

Land 

1 2 

POD $ 300,000 $ 180,000 

Less: ACB (200,000) (150,000) 

Selling expenses (5,000) (2,000) 

Gain and capital gain $ 95,000 $ 28,000 

Taxable capital gain (1/2) $ 47,500 $ 14,000 

Building 

POD $ 400,000 $ 150,000 

Less: ACB (300,000) (170,000) 

Selling expenses (8,000) (3,000) 

Gain and capital gain $ 92,000 $ — 1 

Taxable capital gain (1/2) $ 46,000 $ — 

The lesser of: 

POD net of 

selling 

expenses 

[13(21)] $ 392,000 $ 147,000 

Capital cost $ 300,000 $ 170,000 

$ 300,000 $ 147,000 

Less: UCC 200,000 100,000 

Recapture of CCA $ 100,000 $ 47,000 

This recapture of CCA is included in rental income. Previously, Paul's CCA on his rental properties was restricted 

to $2,000, which was the rental income computed according to the information given at that time. Now Paul's 

rental income allows him to claim the maximum CCA on other rental properties he may have. 

1 No capital loss is recognized on depreciable property. 

Personal-use property 


POD ACB Selling 

expenses 

Capital gain 

Family car 1 $ 15,000 $ 12,000 $ 500 $ 2,500 

Persian carpet 1,200 1,000 2 — 200 

$ 16,200 $ 13,000 $ 500 $ 2,700 

Taxable capital gain (1/2) $ 1,350 

2 The ACB is deemed to be the greater of the following amounts [paragraph 46(1)(a)]: 

Notes: 

$1,000 

cost: $600 

1. The disposition of family car 2 gives rise to a non-allowable loss [subparagraph 40(2)(g)(iii)]: 

POD $ 10,000 

ACB (14,000) 

Loss $ (4,000) 

2. The result is the same for the home computer: 

POD (greater of $1,000 or the POD) $ 1,000 

ACB (2,000) 

Loss $ (1,000) 

[non-allowable — subparagraph 40(2)(g)(iii)] 

Listed personal property 

POD ACB Selling 

expenses 

Net gain 

(loss) 

Painting 1 $ 30,000 $ 2,000 $ 1,500 $ 26,500 

Painting 2 5,000 8,000 400 (3,400) 

Diamond ring 50,000 10,000 — 40,000 

$ 85,000 $ 20,000 $ 1,900 $ 63,100 

Taxable net gain (1/2) $ 31,550 

Part (b): Paul's income for 2009 as determined by Cantax 

1. Start Cantax and open file TX1M6P1. Save the file under your own initials. 

2. At the Index, open the "Taxable capital gains" folder. Double click the form titled "T1-S3: Capital 

gains (or losses)." 

3. Go to area 3 on the form, "Publicly-traded shares, mutual fund units, deferral of eligible small 

business corporation shares and other shares" and enter in the data for ABD Inc. In the first row 

of this schedule, type 200 in the "Number of shares" cell, ABD Inc as the Corporation name, 

1995 as the Year acquired, 45000 as Disposition proceeds, 30000 as Adjusted cost base, and 

2000 for Outlays & expenses. Cantax computes a Net gain of $13,000. Hit the Tab or Enter key 

and a second line will open automatically for you. 

4. Repeat step 3 to report the dispositions of shares for DEF Inc., KING Inc., and QUEEN Inc., using 

the information given in the problem. When you have entered all four dispositions of shares, 

Cantax should report a net loss of $92,000 on the transactions. 


5. Go to area 4 on the T1-S3, "Real estate, depreciable property, and other properties." 

6. In row 1, enter Land 1 for the description, then enter BC for the province/territory, the 

acquisition date, the proceeds of disposition, the adjusted cost base, and the selling expenses. 

7. In row 2, enter the details for Land 2. 

8. In row 3, enter the details for Building 1. 

9. Building 2 is a depreciable property for which there is a loss. Since a loss incurred on the 

disposition of depreciable property is deemed to be nil, there will be no loss reported on this 

schedule. 

10. To complete the reporting of the real estate transactions, open the rental income schedule 

T776#01-1 and use Edit, Clone Form to create T776#04-1. Add the information for the two 

rental properties, Building 1 and Building 2. There is no rental income or expense, but the CCA 

schedules for each property must be completed. Building 1 and Building 2 have recaptured CCA 

of $100,000 and $47,000 respectively. 

11. Return to T1-S3. Scroll to area 7, "Personal-use property." Enter the information for the disposal 

of family car 1 and the persian carpet. 

12. Scroll to area 8, "Listed personal property" and repeat step 11 for the listed personal property 

that Paul sold during the year. Recall that net gains are reportable for LPP. Consider all 

dispositions, not just those on which gains were realized. 

13. Go to the Tax summary, and verify that Paul's taxable capital gains for 2009 are $94,400. If you 

did not get this amount, print the forms listed below using the same steps as in prior lessons, 

and compare your results to those in the solution file TX1M6P1S. 

T1-1 to T1-4 T1 Jacket — Pages 1 to 4 

T1-S3 

Capital gains 

T776#04-1 

Rental statement 4 — Income 

T776#04-2 

Rental statement 4 — CCA 



Module 6 Self-test 

Additional review questions 

The text contains additional review questions, multiple choice questions, and exercises at the end of each 

chapter. The solutions can be found in the accompanying Study Guide. You may find the following end of 

chapter material helpful for additional practice of the concepts studied in Module 6: 

Chapter 7: 

Review Questions 3 to 5 and 7 

Multiple Choice Questions 1 to 5 

Exercises 4 to 11 

Chapter 8: 

Review Questions 2 to 5, 9 and 12 

Multiple Choice Question 1 

Question 1 

Explain why it is important to distinguish between income earned from holding property and the gains and 

losses that occur from the sale of non-depreciable property capital property. 

Solution 

Question 2 

Describe the tax treatment for each of the following transactions: 

Solution 

Question 3 

a. Irene and Alf Gonzola disposed of their Lake of the Woods cottage as well as their Winnipeg 

home and purchased a retirement cottage on Vancouver Island. Their home and cottage were 

both purchased in 1987 and both were sold for substantial gains. 

b. Martin won a new Toyota Land Cruiser in a raffle at the Calgary Stampede. He immediately sold 

the vehicle back to the dealer for its fair market value of $32,000 and purchased a Toyota Camry 

for $29,000. The cost of his raffle tickets totaled $15. 

c. Sacha sold five ounces of gold (commodity) for a total gain of $300. During the same taxation 

year, she sold her shares of H. Morris Ltd. for a total loss of $3,000. Sacha did not sell any other 

investments during the year. 

Distinguish between a net capital loss and an allowable capital loss for tax purposes. 

Solution 

Question 4 

Distinguish between a capital loss on personal-use property and a capital loss on listed personal property. 

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Solution 

Question 5 

Discuss the various relevant factors in determining whether a gain or loss from sale of property is on account 

of capital or income. 

Solution 

Question 6 

Zelda Fitzener inherited a large parcel of land in southwest Edmonton from her husband. Her husband had 

intended to subdivide the land into 20 residential lots and erect luxury estate homes. Zelda would prefer to 

retain the land in its natural green state. Reluctantly she agreed to sell the land, for a substantial gain, to 

private investors for development into a public nine-hole golf course. Zelda inherited the land at her late 

husband’s cost amount. Explain how the gain will be treated for tax purposes. 

Solution 

Question 7 

Three years ago, Shayne Bridges purchased 10,000 shares of Kindled Products Ltd. for $10,000. Last year, he 

purchased another 10,000 shares for $30,000. The shares are now worth $8 each and he would like to sell 

10,000 shares to purchase a home. Advise Shayne as to which group of shares he should sell and what the tax 

consequences will be. 

Solution 

Question 8 

Respond to the following client inquiries. 

a. Alex disposed of a set of coins in 2010 and received proceeds of $10,400. The cost of the coins 

in 1979 was $400. Alex has net capital losses from listed personal properties, carried forward 

from previous taxation years as follows: 

2002 $8,000 

2005 $5,000 

Determine Alex’s 2010 net taxable capital gain from the disposition of his coins. 

b. Two years ago, Micheline loaned $20,000 to her friend’s small business corporation. The 

corporation agreed to repay the loan, plus 10% interest, within 12 months. When the 12 months 

was up, the corporation could not repay the loan, but there was still a good possibility of 

repayment as soon as the corporation was beginning to show a small operating profit. 

Unfortunately, things did not go well and her friend closed the business this year, leaving many 

creditors, including Micheline, unpaid. The corporation has no assets. What are the income tax 

implications to Micheline of this outstanding loan? 

c. This year, Samara sold 15,000 shares of a publicly traded Canadian corporation. She inherited 

these shares from her grandmother 20 years ago, and has provided you with the following 

information: 

Grandmother’s cost, including commission $ 11,000 

Fair market value at date of inheritance $ 32,000 

Proceeds of disposition $150,000 

Disallowed superficial loss 1989 $ 3,000 


In 1988, Samara sold the shares for a net loss of $3,000 and repurchased them within 20 days 

for $25,000. Her CGA at the time informed her that she had a non-claimable superficial loss. 

Calculate the amount of Samara’s taxable capital gain or loss for the current year. 

Solution 

Question 9 

Bonnie Unrah granted an option to Pete Wilson to purchase a parcel of land. The option agreement is as 

follows: 

Date of option agreement: January 2, Year 1 

Consideration: Pete paid Bonnie a non-refundable amount of $2,500 (on January 2, Year 1) for the right to the 

option to purchase the land. 

Agreement: Parcel of land may be purchased by Pete Wilson for total proceeds of $50,000, which includes the 

$2,500 amount previously paid for the right if the option is exercised on or before June 30, Year 3. 

On June 30, Year 3, Pete exercised the option to purchase the parcel of land and paid $50,000 The ACB of the 

land to Bonnie is $10,000. 

Calculate Bonnie’s capital gain for the appropriate years. 

Solution 

Question 10 

This year, Nancy sold several acres of farmland to an arm’s length party for net proceeds of $940,000. The 

cost of the land in 1996 was $240,000. According to the sales agreement, $340,000 was paid at the time the 

agreement was signed and $100,000 was payable at the end of each of the next six years. Compute the 

taxable capital gain Nancy must report in the current year. 

Solution 

Question 11 

Explain how the tax treatment of capital gains encourages capital investment and risk taking. 

Solution 



Self-test 6 solution 1 

Income from holding property (rent, interest, dividends) and the gains or losses arising on the disposition of 

such properties, are treated differently for tax purposes. Income from holding property is taxed as net income 

from property [paragraph 3(a)]. As such, the full amount of such income is taxable at the taxpayer’s marginal 

tax rate. The gains and losses arising from the sale of non-depreciable property, however, are treated as 

capital gains or capital losses. Only a portion of capital gains, currently 50%, are subject to tax. The remaining 

portion is tax-free. Thus, the favourable tax treatment of capital gains, compared to income from property, is 

an important distinction to minimize the taxes payable on such types of "income." 

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a. Since both the cottage and the house were purchased in 1987, only one of the properties may 

be designated as the principal residence of the family unit. The capital gain on the designated 

principal residence will be tax-exempt, by virtue of the principal residence rules [paragraph 

40(2)(b)]. One-half of the capital gain arising on the other property would normally be taxed at 

the marginal tax rate of the owner (Irene or Alf). 

b. The adjusted cost base (ACB) of any lottery prize is deemed by subsection 52(4) to be its fair 

market value. In Martin’s case that is $32,000. Since Martin’s proceeds of disposition of the Land 

Cruiser is equal to that ACB, he does not realize a capital gain. There is no capital gain on the 

lottery winning itself as paragraph 40(2)(f) deems that lottery winning gains are nil. 

c. The income earned on the disposition of gold represents an adventure or concern in the nature 

of trade. Since gold does not have any income earning ability, any increases in value represent 

gains from holding inventories of commodities. Therefore, any gains or losses are on account of 

income and not capital. However, Sacha may have already elected (see IT346R) to treat her 

commodity investments as capital, in which case the gain is a capital gain. The allowable capital 

loss of $1,500 ($3,000 × 1/2) may only be offset against taxable capital gains. Thus, this amount 

becomes a net capital loss, and is eligible for a carryback of three years, and/or an indefinite 

carryforward. If Sacha has elected capital treatment on the gold, then $150 of the loss can be 

used to reduce her capital gain to zero, and the remaining $1,350 becomes a net capital loss. 




An allowable capital loss is one-half of the capital losses arising from the disposition of property in the year. A 

net capital loss is the excess of the allowable capital losses for a taxation year, over the total taxable capital 

gains for that year. In other words, an allowable capital loss is the actual loss amount that is eligible to be 

deducted, while a net capital loss is a "holding account" for allowable capital losses that are waiting to be used 

(offset against taxable capital gains). Net capital losses may be carried back three years, and/or carried 

forward indefinitely. 




A capital loss on PUP is never deductible for tax purposes. Any deficit between a taxpayer’s proceeds and his or 

her adjusted cost base for the property is considered to be an amount representing personal consumption. 

A capital loss on LPP is deductible for tax purposes, but only to the extent of any capital gains on LPP in that 

year. Any unused capital loss on LPP may be carried back three years, and/or forward seven years. The 

rationale is that the LPP items generally will at least retain their value because they are a collectible, rather 

than consumable. 




Whether a gain or loss on the sale of property is an account of capital or income depends upon the following 

factors: 

Primary intent: The taxpayer’s primary reason for buying and later selling the property. In general, if the 

taxpayer intended to purchase the property, hold it as "inventory," and sell it for a profit, the proceeds would 

be treated as income. If the property was held with the intention of earning income from the investment, any 

gain on disposition would be likely deemed on account of capital. 

Secondary intent: The taxpayer’s "default plan" with respect to the investment is also considered. For 

example, if a taxpayer purchased some undeveloped land near a city, with the primary intention of using it as a 

private hunting preserve, but later subdivided the land and sold it as individual residential lots, the gains or 

losses would likely be considered as income. There is a strong indication that, although the land was purchased 

as an investment, there was an underlying intent to sell it as residential lots for a substantial profit. 

Number and frequency of transactions: Where the taxpayer has completed several similar transactions on 

a regularly occurring basis, any gains or losses would likely be deemed to be income, rather than capital. The 

transactions would likely be classified as "an adventure or concern in the nature of trade." 

Relationship to taxpayer’s regular business: Gains or losses arising from transactions that are similar to 

those transactions common in the taxpayer’s regular business would likely be treated as income instead of 

capital. For example, a capital gain earned on common shares by a stockbroker would likely be considered 

income. 

These factors must be considered together. It is the overall tendency, indicated by examining all relevant 

factors, that forms the basis for determining whether any gains or losses on the sale of property are on 

account of capital or income. 




While the land was assumed to be inventory to Mr. Fitzener, Zelda, unlike her husband, is not in the land 

development business. Her gain on selling the land will be treated as a capital gain. The ACB of the land is the 

deemed proceeds realized by her husband at death, which are indicated in the question to be her husband’s 

"cost amount" (inventory carrying value). 




It doesn’t matter which group of shares Shayne sells. These are identical properties and their ACB is calculated 

using the floating weighted average method. 

No. of shares 

Cost 

3 years ago 10,000 $10,000 

Last year 10,000 $30,000 

Total cost $40,000 

Floating weighted average adjusted cost base 

= $40,000/20,000 shares 

= $2.00 ACB per share 

The sale of 10,000 shares at $8 per share results in a taxable capital gain of: 

Proceeds (10,000 × $8) $80,000 

Less ACB (10,000 × $2) $20,000 

Gain $60,000 

Taxable capital gain $30,000 




a. Alex has a taxable capital gain on the coins, which are LPP, of: 

Proceeds $10,400 

Less ACB (minimum rule) 1,000 

Gain $ 9,400 

Taxable capital gain 4,700 

Net capital losses forward* 4,700 

Net taxable capital gain $ 0 

*The 2005 losses forward are useable against the LPP gain; the 2002 losses have expired as LPP 

losses can only be carried forward for seven years. Alex has $300 in LPP losses forward 

remaining. 

b. Micheline can deduct 50% of the capital loss on the bad debt as an allowable business 

investment loss. It is not necessary that she actually dispose of this receivable as subsection 

50(1) allows the loss to be recognized when it becomes a bad debt. If Micheline had not charged 

interest on this loan, she would be unable to do this as the investment would not have been 

made to earn income, and it would then be considered a personal-use property. 

c. A superficial loss is an addition to the ACB of the shares under paragraph 53(1)(f). While the 

original cost of the shares was equal to the FMV at the date of inheritance, this is now irrelevant 

as those shares were sold and new ones acquired. The superficial loss is added to the new cost 

of $25,000. The ACB of the shares then is $28,000. 


Deduct: adjusted cost base 28,000 

Capital gain 122,000 

Taxable capital gain (50%) $ 61,000 




The proceeds of the option are treated as a capital gain at the time the option is granted. In the Year 1 

taxation year, Bonnie reports a capital gain of $2,500 calculated as follows: 


Deduct: adjusted cost base 

(NIL) 

Capital gain $2,500 

In Year 3, Bonnie reports a capital gain of $37,500 calculated as follows: 


Deduct: adjusted cost base [53(1)] $12,500 ($10,000 + $2,500) 

Capital gain $37,500 

From an administrative point of view, CRA would accept the following in Year 3: 


Deduct: adjusted cost base (10,000) 

Capital gain $ 37,500 

The cost of the land for Pete is $50,000. 




Proceeds $ 940,000 

Adjusted cost base (240,000) 

Capital gain $ 700,000 

Less reserve at the lesser of: 

(a) ($700,000/$940,000) × amount not due ($600,000) = $446,809 

(b) 4/5 × $700,000 = $560,000 

Capital gain = $700,000 – $446,809 = $253,191 

Taxable capital gain is $126,596 




The taxation of only 1/2 of capital gains increases the after-tax yield of capital investments and encourages 

this type of investment. In addition, investments in qualified small business corporations and qualified farm or 

fishing properties are encouraged further by allowing a capital gains deduction, provided certain provisions in 

the ITA are met, whereby $750,000 of capital gains may be entirely sheltered from taxation. 

The tax treatment of losses on shares and loans of small business corporations as ABILs, which are deductible 

against all sources of income, reduces the risk of these investments and encourages investment. 

Gains are only taxed when realized and then only when proceeds are received, subject to gains reserve 

restrictions. Therefore, investment is encouraged, as there is no premature taxation of gains. 



Module 6 summary 

Capital gains and losses 

This module begins with a review of why capital gains are subject to preferential tax treatment. Then, the 

basic concepts and rules for the recognition and computation of capital gains and losses are explained before 

discussing the specific rules in calculating capital gains and losses including the special treatment for identical 

properties and depreciable property, and restrictions on the deduction of capital losses and the special rules, 

such as those relating to the principal residence exemption, changes in use of a property including change in 

use of a principal residence and replacement property. 

Capital gains were not taxable before 1972. As part of the 1971 tax reform, it was decided to tax 

capital gains, not as income from a source, but under special rules. 

The preferential treatment of capital gains promotes investments, particularly in risky ventures, 

by giving the investor a potentially higher yield on investment. 

Capital gains are taxed when realized, and not on an accrual basis. There would be much 

difficulty in valuing all capital properties annually in order to determine accrued capital gains. 

The principal residence exemption stems from a presumption that no real economic gain is 

realized when a home is sold and another is purchased. 

The capital gains deduction on small business corporation shares, farm property and fishing 

property was introduced to encourage entrepreneurial risk taking and to support equity 

investments in large and small businesses, including farm and fishing businesses, by Canadians. 

Capital gains and losses occur on the disposition of property that is not: 

eligible capital property 

certain cultural properties 

Canadian and foreign resource properties 

insurance policies 

timber resource properties 

interest of a beneficiary under a qualifying environmental trust 

property in inventory 

Criteria acknowledged by the courts for distinguishing whether income from the disposition of a 

particular property is business income or a capital gain are: 

the primary intent 

the secondary intent 

the period of ownership 

the number and frequency of transactions 

the relation of the transaction to the taxpayer's business or expertise 

The general rules in the ITA for determining capital gains and losses are as follows: 

Section 40 calculates the gain or loss. 

Section 39 restricts properties on which a capital gain or capital loss can occur. 

Section 38 calculates the taxable or allowable portion used in the paragraph 3(b) 

income calculation. 

Section 41 calculates the taxable net gain for LPP used in the paragraph 3(b) 

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income calculation. 

Terminology tells you where you are in the calculation. 

The formula to compute taxable capital gains and losses may be summarized as follows: 

POD (gross amount received or 

$ XXX 

receivable) 

Less: • ACB (established as the 

$ XX 

original cost plus or minus 

prescribed adjustments) 

• disposition costs XX (XXX) 

Gain or loss 

$ XXX 

Gain or loss = capital gain or loss if no 

restrictions 

Taxable capital gain or loss (1/2)* $ XX 

* the actual rate used will depend on the date of disposition of the property 

The actual inclusion rate used under section 38 has varied, depending on the date of disposition. 

Where the capital property is gifted to an eligible donee, the capital gain inclusion rate is zero. 

The taxation of a portion of a gain may be deferred to subsequent taxation years if there is an 

unpaid balance of the selling price at the end of the taxation year. The maximum reserve 

calculation is equal to the lesser of two amounts calculated under section 40. 

Allowable capital losses are only deductible against taxable capital gains. This is done under 

paragraph 3(b). 

No capital loss can be claimed in respect of a depreciable property. 

The capital loss on the disposition of personal-use property is deemed to be nil. 

Capital losses on listed personal property (LPP) are deductible only against capital gains realized 

on LPP for the year, the three preceding years, and the seven following years. This is part of the 

taxable net gain calculation under section 41. 

The adjusted cost base (ACB) and proceeds of disposition (POD) of personal-use property (PUP) 

and LPP cannot be less than $1,000 (the de minimus rule). 

The "floating weighted-average method" is the only method allowed for arriving at a cost base for 

identical assets for tax purposes. 

The capital loss on small business corporation (SBC) shares or debt may, in some instances, be 

classified as a business investment loss (BIL): 

A BIL will become an ABIL (allowable business investment loss). 

The ABIL is first removed from the paragraph 3(b) calculation. 

The ABIL is deductible from any type of income, shown as a deduction under 

paragraph 3(d). 

When a principal residence is disposed of, an exemption is usually allowed for the total gain 

realized, if it was always inhabited by the family. 

A family may designate only one dwelling as a principal residence per year after December 31, 


1981. The exempt portion is part of the section 40 calculation. 

When a taxpayer changes the use of a property, they are deemed to have sold the property at its 

fair market value and to have immediately reacquired the same property at the fair market value, 

which becomes the new adjusted cost base. 

There are a number of elections available to taxpayers who change the use of a property from 

income-producing to personal-use and vice versa. 

Where a taxpayer realizes a capital gain on the involuntary disposition of a capital property or on 

the voluntary disposition of a former business property, the taxpayer may elect, in the year the 

property is replaced, to defer that gain if the taxpayer reinvests the proceeds of disposition in a 

replacement property within a certain time frame.

Module 6: Capital gains and losses - PD Net

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