The article “A deep dive into the ‘strategic’ capital gain and loss planning you should do this year.” was originally published in Financial Post on December 3, 2021. PHOTO BY GETTY IMAGES.
When capital gains are inevitable, use these strategies to reduce your tax.
Tax-loss selling is the act of intentionally triggering capital losses, especially at year-end, to try to offset current or previous capital gains. This may be tougher to do this year than previous years given the S&P/TSX composite and S&P 500 indexes are both up more than 20 per cent so far this year. As a result, some investors may want to consider capital gains planning for 2021.
Investors with taxable non-registered investments can engage in tax-loss selling that can save tax this year or generate tax refunds from past years, but losses can be denied or generate smaller refunds than expected if it is done incorrectly.
A capital gain or a capital loss gets triggered when an investor sells a non-registered investment for a profit or a loss. Tax-sheltered and tax-free accounts such as registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs) are excluded since they are not taxable.
A capital gain is taxable in the year it is realized. If an investor has more losses than gains in a tax year, the losses can be carried back up to three years to offset previous capital gains and may result in a tax refund. If a net loss cannot be carried back to offset prior gains, or an investor chooses not to carry back their loss, they can carry the loss forward to claim against future capital gains.
But taxpayers need to beware of the superficial loss rule when triggering a capital loss. A superficial loss occurs if an investor sells an investment at a loss and buys back the same investment within 30 days. It also applies if you bought the same investment within 30 days prior to selling it at a loss. And it can apply if an affiliated person — such as a spouse or a corporation controlled by you or your spouse — buys the same investment within 30 days before or after your loss is triggered.
Another reason a capital loss can be denied is if you transfer an investment to an RRSP or TFSA account. You can make an in-kind transfer to an RRSP or TFSA and have the fair market value on the date of transfer count as a contribution, but doing so with investments that are trading at a loss will result in the loss not being deductible. It may be best to sell the investment and transfer cash instead, but do not repurchase the same investment within 30 days to avoid the superficial loss rule.
In some cases, you should not use capital losses to reduce capital gains. Let’s say you have a net capital loss that you can carry back to one of the three previous tax years, but your income in that year was relatively low. The tax refund could be at a low tax rate, so saving the loss for a future year with capital gains at higher tax rates may save you more tax.
There may also be situations when you want to consider intentionally triggering capital gains the same way you might intentionally trigger capital losses when tax-loss selling. For example, if you are retired and you are decumulating your investments and have non-registered, TFSA and RRSP investments.
Let’s say you are under age 72, your RRSP has not been converted to a RRIF, and your asset allocation needs rebalancing because stocks have appreciated. You may choose to trigger capital gains in your non-registered account and reduce or avoid RRSP withdrawals for the year. You can do this to effectively plan your income and try to stay within a certain tax bracket.
Also keep in mind there may be unexpected year-end capital gains distributions if you own mutual funds, exchange-traded funds or other pooled funds. These funds are buying and selling each year within the fund structure and may trigger capital gains that are flowed through and taxable to the investor.
This is also a reason to be careful about buying funds towards year-end, since you may get a capital gains distribution that you report on your tax return and pay tax on that you did not benefit from earning. A capital gains distribution is notional and not an actual cash distribution such as a dividend. There may be a lot of capital gains distributions this year-end given how strong stock markets have performed.
Another reason to intentionally trigger capital gains is for charitable purposes. If you donate a stock, mutual fund or ETF that has appreciated in value to a charity, the capital gain is not taxable. You still get a donation receipt for the fair market value of the investment just as if you gave cash. Many charities accept a donation of securities, so if your donation is sizeable enough to justify doing the paperwork, consider donating investments with deferred capital gains.
If you have corporate investments, one advantage of triggering capital gains has to do with your corporate capital dividend account. Capital gains are only 50-per-cent taxable, and corporations can add the 50-per-cent tax-free capital gain to a notional capital dividend account balance that is continuously tracked. A dividend that is paid out from the corporation to a shareholder when there is a capital dividend account balance can be treated as a capital dividend, which is tax-free to the shareholder.
There is paperwork involved to declare a capital dividend, so paying small capital dividends may not be worth it, but larger capital dividends can provide tax-free income. Recalibrating a corporate investment account’s stock and bond allocations, or selling investments that have become overweight positions, may make good investment sense and generate tax-efficient withdrawals for personal cash flow.
Parents or grandparents who have informal or formal trust accounts for family members, especially those with low or no income, should consider triggering capital gains as well, since this allows them to use their low tax brackets and bump up the adjusted cost base of the investments to reduce future capital gains tax.
If you are triggering a capital gain, especially towards year-end, another consideration is whether to do so over two years. For example, part in December and part in January. This spreads the tax over two years instead of one and may result in less combined tax payable.
Some assets, such as real estate, make capital gains planning difficult. Unlike marketable securities, which can be partially sold, real estate tends to be all or nothing. The tax hit can be significant when selling a cottage or rental property that has been owned for a long time.
But there are simple strategies to reduce the tax payable. One is to try to do so in a year when your income is low. This may be easier if you have a degree of control over your income, such as being an incorporated business owner or a retiree taking RRSP withdrawals whose RRSP is not yet converted to a RRIF.
Another option is to contribute to an RRSP in the year of sale to claim a tax deduction. In anticipation of a real estate sale, you could even save your RRSP deductions to claim in the high-income year if your income is not generally as high.
Tax-loss selling gets a lot of attention at this time of year and capital gains are often seen as taboo and something to avoid. Sometimes capital gains are inevitable, but they can also be strategically realized to reduce your current year or lifetime tax payable.
Jason Heath is a fee-only, advice-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.