Your tax situation

Are you taking advantage of every tax deduction and tax credit available to you? Do you have any deferred capital losses?

It is important to know all the different tax credits and tax deductions you are entitled to, because these things can reduce your tax bill. But first, do you know the difference between a tax deduction and a tax credit?

Deduction or credit

A deduction reduces your taxable income. Since our tax system uses progressive tax rates, a deduction represents a different benefit depending on the taxpayer's marginal tax rate. Here's a brief overview:

The chart below presents approximate marginal tax rates for individuals living in Quebec in 2022.

¹The rate that applies to each additional dollar of income.

For an individual with an annual taxable income of $30,000, a $100 deduction represents $27.53 in income tax savings, but for someone with an annual income of $60,000, the same deduction represents tax savings of $37.12.

Unlike deductions, tax credits directly reduce the amount of income tax that is payable. So a $100 tax credit represents a savings of $100. A tax credit has the same value for everyone, no matter what their income is. However, certain credits are reduced when the individual (or family) net income reaches specified tresholds.

There is a difference between refundable tax credits and non-refundable tax credits. Non-refundable tax credits, like deductions, lose their value if you have no income to pay that year. Some non-refundable credits can be transferred between spouses while others can be carried forward.

Examples of deductions that can be claimed:

• Contributions to a registered pension plan or RRSP
• Deductible business investment losses
• Annual union, professional, or like dues (at the federal level only; in Quebec, it is a tax credit)

In some cases, interest costs, support payments to a former spouse, moving costs, legal fees and some home office expenses are deductible.

Capital losses are also 50% deductible, but they can usually only be deducted against taxable capital gains (50% of the capital gain). When capital losses cannot be used in the year they are incurred, they can be transferred back three years against taxable capital gains, as long as the capital gains deduction was not used in the same year. If they cannot be used in the three prior years, they can be deferred indefinitely into the future.

Some of the amounts giving rise to non-refundable tax credits for 2022

¹The 15% federal and provincial rates are applied to the dollar amounts shown in the chart, to determine the value of the credit. At the federal level, the basic credit and the eligible spouse or dependent credit include an amount of $1,679, which is gradually reduced to zero when the individual has taxable income in the 4^th tax bracket.

²Quebec residents do not pay the full federal income tax because of the 16.5% abatement. The actual value of the federal tax credits is therefore 12.53%.

Are you familiar with the retirement income-splitting rules?

Since the 2007 tax year, residents of Canada can split their pension income with a married or common law spouse in a lower tax bracket.

When they prepare their income tax return, retirees can decide to declare up to 50% of their eligible pension income on their spouse's tax return, if the spouse is in a lower tax bracket. This amount is then deducted from the retiree's income. The income taxes deducted at source are also transferred in the same proportions as the pension income.

This is not a real transfer of money between spouses, but a tax election made each year in their respective income tax returns by completing the required schedules (T1032 for the federal return and Schedule Q for Quebec).

The spouse to whose return the income is added must give their written agreement for the year in question. Both spouses are equally responsible for the income taxes that arise from this election.

Eligible pension income

For individuals aged 65 or over, eligible pension income includes life annuity payments from a registered pension plan (RPP), payments from a registered retirement savings plan (RRSP) or a deferred profit-sharing plan (DPSP) and payments from a registered retirement income fund (RRIF) or from a life income fund (LIF).

For federal purposes only, eligible pension income for people under 65 includes life annuity payments from an RPP and some payments received following the death of a spouse or common law spouse.

No matter when during the year the individual turns 65, all pension income received that year is eligible. The age of the spouse to whom the income will be attributed does not matter, but each couple should analyse their tax situation carefully before splitting eligible pension income.

The greater the income gap between the spouses, the greater the tax savings. Some retirees may even be able to recover their Old Age Security (OAS) benefits using these rules. Make sure, though, that only one of the spouses repays the OAS because of high income.

In addition to the tax benefits of income splitting, couples can double their pension income tax credits. For people under 65, only pension plan annuities are eligible for this credit. For people 65 and over, all income on the eligible pension income list provides a pension income credit of up to $2,000 on the federal level. In Quebec, the pension income credit can be obtained on a maximum pension of $2,939. Note that in Quebec only, age is not taken into consideration to determine eligibility for the credit for pension income.

Do you know what your average tax rate is? How about your marginal tax rate?

Canadians are taxed under a "progressive" system, which means that the tax rate increases as taxable income increases. We pay income taxes on income earned each year, not on our accumulated assets.

Marginal and average tax rates

The marginal tax rate is the rate that applies to the last dollar of taxable income. It is often used to evaluate the tax savings on an RRSP contribution or, inversely, the additional taxes resulting from additional income.

The average or effective tax rate is the taxpayer's total taxes divided by total taxable income. For example, a taxpayer with taxable income of $50,000 in 2021 will pay about $9,964 in taxes, or an average tax rate of about 20%. This rate is used to evaluate total taxes on projected income, such as retirement income.

The chart below presents the average tax rates and marginal tax rates for different levels of income of Quebec residents in 2022.

¹Combined federal-provincial tax rates for single taxpayers.

Are your debts structured to maximize interest deductibility?

The basic tax principle of interest deductibility is as follows: a taxpayer can deduct interest paid or payable on money borrowed as long as the money is used to draw business or property income. So it is in your interest to prioritize the repayment of loans that do not give rise to this deduction, such as mortgage loans on family homes, car loans, or other debts incurred for personal use assets.

There is a tax technique called "cash damming" that consists of structuring the business of a self-employer worker or rental building owner to make the interest deductible on any loan indirectly incurred for personal purposes. How? By using gross self-employment or rental income to pay personal expenses and repay personal loans with non-deductible interest. All expenses related to the business or building upkeep are paid using a line of credit, probably secured by the mortgage, and used exclusively for the business or rental building. The interest payable on this line of credit is deductible, because the loan is incurred for the purpose of drawing property or business income. Certain conditions must be met to use this technique.

Do you know how much income tax to pay when you sell your rental buildings?

Capital gain

When you sell a rental building at a price higher than the purchase cost, you have to declare a capital gain. The capital gain is the difference between the sale price and the purchase price. Capital expenses reduce the capital gain, because they add to the purchase price. The taxable capital gain is 50% of the capital gain and is added to your annual income. You cannot realize a capital loss on the "building" portion, only on the "land" portion. This will be 50% deductible and applicable against a taxable capital gain only. For the "building" portion, a loss is deemed to be a terminal loss.

Recapture of depreciation

In addition to declaring a capital gain, you must also add the recapture of depreciation to your rental income in the year of the sale. Recapture of depreciation is the difference between the capital cost (purchase price of the building only, excluding the land) and the non-amortized portion of the building at the time of the sale (commonly called UCC, for undepreciated capital cost). The result is 100% taxable income in your income tax return for the year and represents all depreciation costs deducted during all the years you held that rental building.

Claiming depreciation expenses is a method of tax deferral. The point is to reduce your taxable rental income for all the years you own the building. It is even better if you can sell in a year when your marginal tax rate is low. The depreciation deduction is calculated, using a pre-established percentage, on the cost of the building excluding the land, because land is not a depreciable asset. Depreciation reduces your taxable rental income. Over the years, if you do major renovations or extensions to your buildings, these capital expenses are added to the UCC balance in the year they are incurred.

Terminal loss

If your building suffers a significant loss in value and you have not claimed much depreciation, you will probably be in a position of terminal loss, rather than recapture of depreciation. This terminal loss is deductible against all of your other income, not only against taxable capital gains.

As the land may be subject to a capital loss (50% deductible against taxable capital gains only) and the building subject to a terminal loss, it is important to divide your sale price between the land and the building when you calculate your capital gain or terminal loss.