At this time of year, you will hear a lot about tax loss harvesting. This is the strategy of selling your losing positions near the end of the tax year to lock in the losses.
Tax loss harvesting is mainly used to offset capital gains realized during the current tax year, but they can be carried forward indefinitely to offset future capital gains or used to offset capital gains realized in the prior three years.
When making these transactions, it's necessary to understand the "superficial loss" rules. Basically, you—or any person affiliated to you—can not repurchase other identical assets 30 days before or after making the loss sale in any account. This generally does not apply to selling at a gain! Read this for more details.
Capital Gains Harvesting
Capital gains harvesting is intentionally selling assets in taxable accounts to trigger capital gains tax, particularly when these gains are realized at very low rates or no tax events.
After the sale is made, the investor repurchases the asset. This increases the cost base of the assets which means less tax as a portion of each future sale.
This lucrative type of tax trigger is typically only available to early retirees or small business owners. It does not work if you are earning income working or have fully taxed pension income. It will work especially well in the future when retired people are able to have substantial assets in their TFSA.
Understanding Capital Gains Taxation
In Canada an investor must pay tax on any capital gains which are realized during the year. A capital gain (or loss) is the difference between your adjusted cost base of a position and your selling price. Your adjusted cost base of any particular investment is the weighted average purchase cost plus any adjustments for Return of Capital distributions.
For tax purposes, only 50% of the capital gain is included for taxation at your marginal tax rate. This is very different from being taxed at 50% of the marginal tax rate!
Let's say you purchased $100,000 of XYZ. It's now worth $200,000 and you sell all of it. This means you have a $100,000 capital gain. At 50% inclusion (the correct way to calculate), you could essentially pretend you have a taxable regular income of $50,000. Your tax bill on this amount is $8,910 for the 2017 tax year, or a true rate of 8.91% after adjustments if you live in Ontario.
This is very different than the common misunderstanding that the $100,000 capital gain would be taxable at 50% of the marginal tax rate of 43.41% at that income level. That math would result in a net tax rate of 21.7% for a tax bill of $21,700.
Other Income Issues
Capital gains harvesting is best for early retirees or small business owners. The reasons for this are simple; you don't want to have any other income aside from maybe a small amount of Canadian dividends eligible for the dividend tax credit.
Early retirees often have no other earned income. They can choose their income mix from RRSPs, TFSAs, and non-registered (Cash/Margin) accounts as they see fit.
Small business owners can also have substantial income which is not taxed at the personal level. This may be in the form of returned shareholder credits or exempted capital gains. Your professional accountant could explain these in detail.
Capital gains harvesting works because you are taking advantage of the basic personal deductions available to all Canadians which run from around $8,000 to $19,000 depending on the province.
You can also add in charity contributions, investment expenses and carrying costs, and a few other deductions. As well, Canadian dividends are taxed at negative rates for incomes under $46,000 in many provinces and can be used to offset other taxable income.
Capital Gains Harvesting Example
Let's say Mr. & Mrs. Grand are early retirees in Ontario who invested $10,000 per year in their joint taxable account from 2001 through 2016. Each year on June 30 they purchased as many units of Brookfield Asset Management (BAM-A.TO) as possible. They retired in 2017 and have no reportable income other than the dividends from BAM-A.TO.
Here are the details of the Brookfield investment (red highlights are draw-down years):
As you can see, with no new purchases in 2017 the cost base per share is $13.49 while the total value per share currently is $56.40. If the Grand's sell any of Brookfield shares, their capital gain would be $42.91 per share sold. In other words, on the entire account the Grand's have a total capital gain of $509,186.
In 2017 they would receive an annual eligible dividend of approximately $0.72 per Brookfield share. That's a total income of $8,542 split between two adults.
At this income level, and adjusting for the negative tax on the dividends, the Grand's could realize around $28,000 each in capital gains without paying a dime of income tax. This means they could sell 1,305 shares of BAM-A.TO in 2017. The total sale value would be $73,602 with $55,997 of that amount being a capital gain.
After the sale settles, they could repurchase the 1,305 shares of BAM-A.TO in their account. Their account value would still be worth $669,186 but now the cost base has increased from $160,000 to $216,058. (10,560 shares at $13.49 plus 1,305 shares at $56.40).
This means the capital gain liable to taxation has shrunk by $56,056. They will never be taxed on that capital gain again.
They repeat this process year after year as long as they can use their TFSAs or other no-tax income to cover their living costs.
After a few years, as the share price moves up and down, their cost base will be near the current share value (as in 2024). At this point, they could sell all their shares of BAM-A.TO and have a total taxable capital gain of just $20,000.
If the share price falls under $51.25, they could sell their position in BAM-A.TO at a capital loss, carry that loss forward, and purchase shares of a different company instead (being mindful of the superficial loss rules).
Capital gains harvesting has the potential to save investors a substantial amount of tax on their investment gains in their non-registered (Cash/Margin) accounts.
There are some nuances you should know of, particularly if you are buying and selling a position multiple times throughout the year. Before using this strategy to reduce tax, you should talk to a professional accountant to get the exact process right and make sure it works for your situation.
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