capital losses – The Rich Moose | A Better Canadian Finance Blog

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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As 2017 is quickly winding up, it's time to make some financial decisions. Here's a list to keep you on track.

Asset Allocation Adjustments

If you're not making regular contributions to your investments any more, or if those contributions are small relative to your total investments, it might be time to re-balance to your desired asset allocation targets.

Re-balancing should take place once or twice a year and the end of the year is as good a time as any. Other memorable dates might be around a birthday or anniversary. Re-balancing is an important component of tactical asset allocation portfolios. The long-run effect is you are selling high and buying low, reducing risk and increasing returns.

Tax Loss Selling

If you've had any investments in non-registered accounts only that performed poorly over the year, now is a good time to get rid of them and lock in the capital loss (which can be carried forward indefinitely to offset future capital gains).

There are just a few asset classes that performed poorly this year, but you may have a bad investment in an oil stock or some losing positions in a "fun account". Now is the time to get rid of these, lock in the loss for future tax benefits, and hopefully learn your lessons in speculation.

If any losing holdings are part of your long-term, well-thought-out investment plan, sell and substitute for a comparable (but slightly different) low cost ETF. For example, if you lost money in the energy sector holding iShares XEG.TO, sell it and replace with BMO's ZEO.TO to get similar exposure in a slightly different index product.

Tax Gain Selling

In particular circumstances it can be very beneficial to lock in capital gains for tax purposes in your non-registered account only. If you had no taxable income this past year, or your income was drastically lower and in a low tax bracket, you should consider realizing capital gains now.

For example, let's say you and your wife retired last year in Alberta with enough money in a savings account to pay for all your 2017 expenses. Your investments total $1 million, of which $500,000 is in a taxable account. You have zero realized income for 2017 at this point beyond $10,000 in Canadian dividends. You also realized a 10% return this year, translating to a $50,000 unrealized capital gain for this year.

Contrary to popular thought which preaches indefinite deferral is best, you should actually realize that gain now, pay the taxes owing, and reinvest in a similar ETF. Your tax bill would be $0, and you still have a total of $550,000 invested in your account. However, now your cost base is increased by the $50,000.

You locked in a gain, legally paid no tax, and will never pay tax on that increase in wealth again. If the market drops, you would also claim capital losses on the new, higher cost base which could further offset future capital gains tax.

This strategy can be very lucrative when done right!

Spousal Loans

Spousal loans can be a great tool to move investment income from a high earning spouse to a low earning spouse, thereby reducing the overall tax bill and helping to ensure both spouses can achieve equal income in retirement. It's generally only worth the hassle if the income gap is large, or if the loan is for a considerable amount of money.

All loans must be properly recorded in a promissory note and the interest rate has to be equal to or higher than the prescribed rate for employees and shareholders. The loaned money must be invested in a non-registered account. Here's how it works:

Fred and June live in B.C. where Fred is a asphalt worker who works 4 months of the year and earns $20,000 while June is a lawyer who makes $200,000. Fred tops up his TFSA and saves the rest (as he should), while June fills her TFSA, RRSP, pays all the household expenses, and still has $50,000 a year for savings. She has accumulated $300,000 in her investment accounts.

June makes a $300,000 loan to Fred at the current prescribed rate of 1%. Fred invests this money and must pay June $3,000 a year in interest payments. However, Fred earns 2% in dividends and 4% in unrealized capital gains on the investment.

Fred's total income goes up $6,000 at negative tax rates (Canadian dividends in B.C.), but he deducts the $3,000 interest cost at his marginal tax rate from his $20,000 income. His tax bill is much lower now and his assets are much higher. The capital gains will also be taxed at much lower rates at his income level, and he's far more likely to benefit from tax gain/loss selling strategies.

June's income goes up $3,000 from the interest income, but drops the $6,000 in dividend income. At her tax bracket, dividends are taxed at 28% anyways so her total tax bill is actually lower as well. She also is not in a position where she might be forced to realize capital gains or other investment income at high tax rates as her investments are now all sheltered in RRSPs and TFSAs.

You can play around with this strategy for your own situation using my favorite tax calculator. Because of the extremely low prescribed interest rate, there has never been a better time to use this strategy!

CRA's My Account

This is a simple housekeeping item that everyone puts off. If you haven't already, sign up online for My Account with the CRA. It's free, it's easy, and all your tax details will be in one convenient place.

With this account, you can check previous year's tax returns, you can look up your RRSP and TFSA contribution limits, and you can use it to set up online payments to and from your chequing account.

The Wonderful TFSA

The increase has been announced! You will be able to put another $5,500 into your TFSA account in 2018. That's $11,000 in new contributions for a couple, or a total of $57,500 in cumulative room per person if you were 18 years old in 2009. Make the most of this tax-free forever account!

If you finally woke up and plan to actually invest your TFSA money instead of getting that pitiful 0.5% at your local bank, or are planning to switch to a new brokerage or advisor for your TFSA, now is the time to make your move to avoid the transfer fees some firms charge. Here's how:

Complete the paperwork to open a new TFSA account at a brokerage
Sell your investments in your old TFSA
Transfer/withdraw the money from your old TFSA before December 22 and put it in your regular chequing account
Enjoy Christmas season and wait patiently
In January 2018, put the money into your new TFSA account up to your total contribution limit
Invest the money in your new TFSA by purchasing growth assets like stock ETFs

Simple, simple rules: withdraw in 2017 from old account, wait, then contribute in 2018 to new account. Never do both in the same year or the CRA will classify it as if you contributed twice to your TFSA. This avoids the weird double contribution penalty situation some people have found themselves in.

RRSP Housekeeping

It's time to take a look at that RRSP account. If you're retired and planning to draw income from your RRSP, make the appropriate withdrawals before the end of December. (I believe the 27th is the last day this year to ensure the transaction settles).

I'm a big fan of income tax targeting for retirees. Basically that means strategically realizing income from various sources to target an acceptable income tax rate. For example, if you've targeted an acceptable tax rate of 10% in retirement and so far all you've earned is some Canadian dividend income and a small amount of capital gains, it could be worthwhile to increase your taxable income on paper by withdrawing a strategic amount from your RRSP, paying the tax on the withdrawal, and investing that money in your TFSA or non-registered account instead where future taxes will be lower.

You should also get ready for the so-called "RRSP season" in the start of 2018. If you are planning on going back to school, are saving for retirement, or a downpayment on a house purchase, you can contribute to your RRSP up to the end of February 2018 and have that contribution count against your income tax in 2017. This means you get your refund shortly after your contribution is made as most people do their tax return in March or April.

If you're making regular contributions to your RRSP throughout the year, be smart and complete a T1213 form today for your contributions in 2018. It takes a few minutes and a postage stamp, but you will see higher paycheques all year long as your tax deductions are reduced.

If you get a big tax refund cheque in April, you've really given the government an interest free loan. This is not ideal!

Smith Manoeuvre

If you own your own home and have at least 35% equity in the property, you should consider setting up a Smith Manoeuvre. This strategy uses home equity to invest in higher growth assets while helping you save thousands of dollars in tax over your lifetime.

It takes some work and careful planning to set up the Smith Manoeuvre properly, so the holidays can be a good time to tackle this job.

If you already have a Smith Manoeuvre in place, now could be a good opportunity to clean up your accounts and get your paperwork in order for tax season. If you're invested in assets that pay RoC income, you might opt to sell those and invest in assets that pay dividend income only so you don't have to make those tedious RoC adjustments.

Blog Housekeeping

Thanks for reading this blog and sharing with your friends! I'm currently averaging around 600 unique readers and nearly 2,500 page views per month—a huge increase having started from nothing in January. By the end of 2017, I will have about 6,000 visits and 15,000 page views over the course of the year!

I will continue to play with the format of the blog posts, so expect some changes throughout 2018. It's been a lot of work researching information and writing posts, but I've learned a lot myself in the process and I feel it's making me a better manager of my own money.

If you have any suggestions on how I can improve the blog, or any financial-type questions you feel deserve a blog post, feel free to leave a comment.

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.

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