Computation of Income in Canada: A Plain-Language Guide to Section 3 of the Income Tax Act (2025 Edition)

If you want to pay the right amount of tax in Canada, the very first number you must get right is your “income for the year.” Every other calculation—credits, deductions, federal tax, provincial tax—starts there. The Income Tax Act explains how to find this figure in Section 3, often called the computation of income rule.

Unfortunately, the Act was written by lawyers for lawyers, not for everyday Canadians. This article rewrites Section 3 in clear, simple English. It also shows you how the four-step formula works, why the order of those steps matters, and how to avoid the most common mistakes that trigger Canada Revenue Agency (CRA) reassessments.

You will need some patience; the rule is long. But if you stick with the examples and tips that follow, you will be able to calculate your income like a pro, keep the CRA happy, and maybe even lower your tax bill. The article is roughly 3 200 words, so grab a coffee and settle in.

Why you should care about Section 3

Think of your tax return as a ladder. Section 3 is the bottom rung. If that rung is weak, the whole ladder wobbles. Here is why Section 3 matters:

• It tells you which dollars count as income and in what order.
• It decides whether a loss can reduce this year’s tax or must be carried to another year.
• It prevents people from doubling up deductions or hiding high-tax income under low-tax labels.
• The CRA audits thousands of returns each year. A huge share of those audits start with errors in the four-step formula.

By the time you finish this guide, you will understand how to climb that first rung safely.

Key ideas in everyday language

Before diving into the steps, let’s map the basic language you will meet. Keep these ideas in mind as you read.

– Income from all sources: salary, self-employment, rent, interest, dividends, foreign earnings—everything except capital gains and losses.
– Capital gains and capital losses: money you make or lose when you sell investments. Only half the gain is taxable. Only half the loss can be used to offset gains.
– Subdivision E deductions: personal deductions such as RRSP contributions, moving expenses, childcare, spousal support, and some other items that sit in a special list of the Act.
– Business or property loss: any loss after you deduct all normal business costs and capital cost allowance (depreciation).
– Non-capital loss: a loss that is big enough to drop your income below zero. You cannot use that excess to create a negative income this year, but you can carry the amount back three years or forward twenty.
– Allowable business-investment loss (ABIL): half the loss on certain small-business shares. An ABIL has unique rules.

Remember these ideas. They keep popping up in the four-step formula.

The four-step formula in Section 3

Parliament put Section 3 into four lettered paragraphs, but the entire rule is really one long sentence. In plain words, Section 3 says:

1. Add up all your regular income (but leave out capital gains and losses for the moment).
2. Work out your net taxable capital gain for the year and add that to the first number.
3. Subtract the deductions that belong to Subdivision E.
4. Subtract your current-year losses from any office, employment, business, or property as well as any allowable business-investment loss.

If the result after these four moves is positive, that is your income. If the result is zero or negative, your income is deemed to be zero and the extra negative amount becomes a non-capital loss for other years.

That is the whole rule. The job now is to see how each step works in practical terms.

Step 1 – Add all regular income

The law starts by saying, “Determine the total of all amounts each of which is the taxpayer’s income for the year from a source inside or outside Canada.” In plain English: Add up every dollar you earned during the year, no matter where you earned it, and no matter whether it is taxed here or abroad, but leave out capital gains and losses for the moment.

What belongs in this pile:

• Salary, wages, overtime, tips, bonuses
• Commissions and honouraria
• Employment insurance benefits, taxable social benefits
• Self-employment or freelance profits after expenses
• Rental income, royalty income
• Interest from bank accounts, bonds, mortgages
• Dividends from public or private companies
• Foreign income of any type, converted to Canadian dollars

What does not belong in this pile:

• Capital gains or losses (they wait for Step 2)
• Tax-free savings account (TFSA) income
• Lottery or casual gambling winnings (unless gambling is your business)
• Life-insurance death benefits paid to you as beneficiary

Foreign income tip: If you earn U.S. dollars or euros, convert each payment using the Bank of Canada daily rate or the average annual rate. Keep a spreadsheet printout. CRA auditors love clear conversion evidence.

Step 2 – Add net taxable capital gains

Next, Section 3 tells you to find out if you have a net taxable capital gain for the year. Here is how you do that in plain steps:

1. List each capital property you sold—shares, mutual-fund units, real estate, cryptocurrency, and so on.
2. Work out the capital gain or capital loss on each deal. Gain is selling price minus cost. Loss is cost minus selling price.
3. Separate gains and losses on listed personal property like art or jewellery.
4. Add up all gains, add up all losses, and offset them.
5. If you still have a gain, multiply that amount by 50 percent. The result is your taxable capital gain.
6. If you have a net loss, stop. You do not put that loss into Step 2. Instead, it becomes a net capital loss that you can carry to another year.

Special rule for ABIL: If you sold shares of a small Canadian business at a loss and the company qualifies, half of that loss (the allowable part) can reduce any type of income. You claim that in Step 4, not in Step 2.

Why is this order so strict? Because the government wants capital-gain math kept separate from regular income. Mixing the two too early can create double deductions or extra losses that are not allowed.

Step 3 – Subtract Subdivision E deductions

Now that you have added regular income and taxable capital gains, you can subtract certain personal deductions. The law keeps these items in a short list under Subdivision E. If a deduction is not on that list, you cannot use it here.

Common Subdivision E deductions:

• RRSP contributions, including those to a spousal RRSP
• Contributions to a pooled registered pension plan (PRPP) if you are self-employed
• Repayment of COVID-19 benefits that you had to pay back in a later year
• Moving expenses, but only if your new home is at least 40 kilometres closer to a new job or university program
• Child-care expenses for day care, nannies, and day camps, normally claimed by the lower-income spouse
• Spousal or child support payments that are court-ordered and made in cash
• Certain adoption expenses
• Northern residence deduction if you live at least six months in prescribed northern zones

What does not belong here:

• Capital-cost allowance (that is a business expense)
• Home-office costs for self-employed individuals (those reduced Step 1 income already)
• Charitable donations (they are non-refundable tax credits claimed later, not deductions in Section 3)

A common mis-step is to place RRSP contributions in the business-income section of your books. The CRA will re-add those amounts to income and then allow them only in Step 3. To avoid that headache, always treat RRSP as a personal deduction, not a business expense.

Step 4 – Subtract current-year losses

The final move is to subtract losses that happened this year in any of your businesses, rental properties, or other money-making activities. You also subtract any allowable business-investment loss (the ABIL). Here are the key ideas:

• The loss must be a “true” loss after you have already claimed every normal business deduction, including depreciation on equipment.
• If you had more than one business, add the profits and losses first, then apply the net figure here.
• Rental loss is after mortgage interest, property taxes, upkeep, management fees, and depreciation.
• ABIL is half of the loss on qualifying small-business corporation shares.

If you still have a negative balance after Step 4, Section 3 tells you that your income is deemed to be zero. The leftover negative number becomes your non-capital loss. You can carry that loss back three years to recover tax you already paid or forward twenty years to reduce future income. You choose when to apply it by filing adjustment requests, and you do not have to use it all at once.

Where does Section 4 fit in?

You might wonder, “What if I earned income in two provinces or two countries? How do I split expenses fairly?” That is when Section 4 comes in. Section 4 is simple once you see why it exists: it stops people from pushing too many deductions into the highest-tax source or province.

Here is the plain-language rule:

• Work out the income or loss of each source as if that was your only source of income for the year, and allow only the expenses that belong 100 percent to that source.
• If your duties or business were carried on partly in one place and partly in another, treat the part in each place as if it were the only business in that place. Allocate shared expenses reasonably—often by time sheets, sales figures, or mileage.
• Personal deductions in the Subdivision E list cannot be split by source or place. They are applied at the overall level only.

Complete numerical example

Let’s follow Lisa, an engineer in Nova Scotia with side income.

Facts

• Salary: 100 000 dollars
• Side consulting profit: 18 000 dollars
• Rental loss on Florida condo: minus 6 000 dollars
• Sale of Canadian mutual fund units: capital gain 30 000 dollars
• Sale of personal jewellery: capital loss 4 000 dollars (listed personal property)
• RRSP contribution: 24 000 dollars
• Moving expenses: 8 000 dollars (moved 80 km closer to her new job)
• Spousal support paid: 5 000 dollars
• Loss on small-business shares (qualifies for ABIL): 12 000 dollars

Calculation

Step 1: Regular income

• Salary 100 000
• Consulting 18 000
• Rental loss minus 6 000
  Total Step 1 = 112 000 dollars

Step 2: Capital gains and losses

• Mutual fund gain 30 000. Half is taxable = 15 000
• Jewellery loss 4 000. Half is allowable = 2 000
  Net taxable addition: 15 000 minus 2 000 = 13 000
  Add to Step 1 → subtotal 125 000

Step 3: Subdivision E deductions

• RRSP 24 000
• Moving expenses 8 000
• Spousal support 5 000
  Subtotal deductions: 37 000
  125 000 minus 37 000 = 88 000

Step 4: Current-year losses

• ABIL (half of 12 000) 6 000
  88 000 minus 6 000 = 82 000

Lisa’s income for 2025 is 82 000 dollars. She will move on to the next parts of the return to claim credits and calculate her final tax. Note that her listed-personal-property loss that exceeded gains receives no immediate tax relief; it can only be used against future LPP gains.

Planning tips and common errors

1. Harvest losses before year-end. If you hold stocks with built-in losses, selling them in December can offset gains in Step 2 and cut this year’s tax.
2. Time RRSP deposits. Large RRSP contributions have the most power when your total income is higher than usual.
3. Log work days and kilometres. If you work in more than one province, clear records help you allocate income under Section 4.
4. Keep capital documents. You must show original cost, selling price, and brokerage statements for every gain or loss.
5. Do not double-claim deductions. RRSP contributions appear only once in Step 3, never in business expenses.
6. Check the 40-kilometre moving rule. Measure with a reliable map app and print the screen. CRA often asks for proof.

CRA audit hot-spots

The CRA runs data-matching software that flags returns for review. Here are the top triggers linked to Section 3:

• Inconsistent capital-gain reports. Your T5008 slips and Schedule 3 must line up.
• Large moving expense claims without distance proof.
• ABIL claims where the company fails the “small-business corporation” test or where you cannot prove share ownership.
• Multi-province business income that does not match GST or payroll files.
• Foreign income omissions. CRA can access international banking data under global exchange agreements.

Simple rule: keep all paperwork for at least six years. If you see a CRA enquiry letter, respond with neat, dated documents. That alone can shorten an audit.

Frequently asked questions

Do I have to include foreign salary in Step 1 even if it was taxed overseas?
Yes. Residents of Canada pay tax on worldwide income. You can claim a foreign tax credit later, but the income must first enter Step 1.

Can capital losses reduce my salary income?
No. Capital losses only offset capital gains. Excess losses become net capital losses that can be carried to other years.

What is an allowable business-investment loss in plain words?
If you bought shares of a qualified small Canadian corporation and later sold them for less than what you paid or the company went under, half that loss can reduce any kind of income. It is claimed in Step 4.

I moved 35 kilometres closer to my job. Can I claim moving expenses?
No. The Act requires at least a 40-kilometre reduction in commute by the shortest usual route.

My income after Step 4 is negative. Do I get a refund?
No refund against zero tax. Your income is deemed to be zero, but the extra negative amount becomes a non-capital loss to use in other years.

Year-end action checklist

• Gather all employment T4 slips and confirm they match deposits.
• Print a brokerage gain/loss summary.
• Verify listed-personal-property transactions and keep auction receipts if any.
• Add up RRSP and spousal RRSP deposits made in the calendar year and the first 60 days of the next year.
• Confirm mileage logs if claiming business or multi-province income split.
• Check 40-kilometre distance if you moved this year.
• File Section 116 paperwork fast if you are a non-resident selling Canadian real estate.

Completing this list puts your miles ahead of most taxpayers.

Conclusion and next steps

Section 3 looks scary on paper, but the logic is simple: start with all regular income, add taxable capital gains, subtract the personal deductions on the special list, then subtract your current-year losses. Follow that order every year and keep clean records, and CRA audits will go faster—or never arrive at all.

Still unsure? A professional accountant can walk you through the numbers line by line.

For personalized help, contact BOMCAS Canada Tax and Accounting at 780-667-5250 or visit bomcas.ca.