Managing Capital Losses: Four Discussion Points

The selling of capital assets is a permanent transaction, one that can lock in gains and losses and leave taxpayers with either positive or negative tax results. Structuring transfers of assets to family members can be just as precarious, without financial guidance from learned and experienced specialists, that is.

Here are four discussion points to consider for year-end planning purposes if an actual or deemed disposition is imminent in a non-registered financial account or with non-financial assets, not including depreciable assets:

Selling is permanent. A capital loss occurs when certain types of assets are disposed of, for less than the total of their adjusted cost base (ACB) and any related outlays and expenses. Capital losses incurred will generally offset capital gains earned in the year, but not other income. While you can buy the securities back, you will have to wait until at least 31 days after the sale. Otherwise the losses are considered superficial and not claimable.

Deemed dispositions. A taxable event can also happen in certain circumstances when there is a transfer of the assets, but not a sale. Examples of “deemed dispositions” include permanent departure from Canada, when shares held are converted, redeemed or cancelled, when options to acquire or dispose of property expire, when a debt is settled or cancelled or when an asset is transferred to an individual or trust. Generally, the proceeds of disposition will be the Fair Market Value (FMV) of the asset at the time of disposition. This is important, as, for some assets, an appraisal is necessary to justify that valuation for tax purposes.

Structure Family Transfers Carefully. When assets are transferred by way of gift to your spouse or common-law partner, the capital gains or losses will be deferred until the asset is actually disposed of, resulting in a tax-free rollover at the time of transfer. This rule can be avoided when a spouse pays FMV for the property or when a spousal loan for that amount is drawn up. But again, there are special rules, to prevent investors from crystallizing losses without actually disposing of the property. Such losses will eventually be realized when the property is finally disposed of to a third party. Professional help is a must in these cases.

Don’t flip losers to RRSPs or charities. When you transfer securities to either your RRSP or to a registered charity, that transfer will be taxed as a disposition at fair market value. Unfortunately, if the value of the securities has gone down, losses on transfers to your RRSP are deemed to be nil and therefore cannot be claimed. So transfer securities with accrued gains instead. That gain must be reported on your tax return before the security loses its tax attributes inside the registered accounts.

To fund your charities, be aware that while you can claim a loss when you donate shares, there are valuable income tax benefits to transferring qualifying shares with accrued gains. Not only do you get the donation credit for the FMV, but your capital gains are also exempt from tax. The plays: Either transfer shares that have an accrued gain, or sell the losers first and then contribute the proceeds to charity. In both cases, you will receive a donation receipt that will reduce your taxes payable.

However, if you wish to claim the Super Donation Tax Credit, available until 2017, transfers won’t count: You will need to donate up to a maximum of $1000 in cash; something you can do by selling your losers.

Cutting your losses, in short, is all about what you get to keep over time in a volatile investment climate, by averaging down the taxes on winners with the claims you can make on the losers.

Cut Your Losses

Greed and fear: one drives prices up, the other drives them down. These are the two emotions that make for fascinating bull and bear markets. To get the results you want in either trend, timing, of course, is everything.

Disciplined investors sell at the top of a cycle and buy at the bottom. However, they also pause long enough, before crystallizing either euphoric gains or staggering losses, to understand the real dollar effect of their actions, after taxes. This is especially important at year end, a time to review non-registered portfolios to offset capital gains of the current tax year with losses.

How do capital losses impact your tax return? First, they cancel out this year’s capital gains. After this, unabsorbed losses can be used to reach back to recover taxes paid on capital gains incurred in any of the previous three years. That’s a great way to maximize the returns of a prior bull market and increase cash flow now, you can use the tax savings for reinvestment or to pay down debt.

But what happens if you had no capital gains this year? Capital losses are still valuable. They can be carried forward – indefinitely – to offset capital gains in the future; a great way to get ready for tax savings on the capital gains accrued in the next bull run.

There’s more good news: if you don’t have another capital gain as long as you live, there is a bonus at death: those capital losses can be used to offset all other income in the year of death and in the immediately preceding tax year. (But, don’t worry things; will likely turn around!)

If you have missed reporting your capital losses in the past, part of your year end planning should include making an adjustment to prior filed returns to include those losses. You can go back 10 years, so be vigilant; losses incurred in tax year 2005 will not be recoverable after December 31, 2015.

Prudent tax loss selling also includes scheduling an appointment with both your tax and financial advisors. It would be good to have them both present at the same meeting, in fact. The financial advisor can report on accrued gains in your non-registered accounts; the tax accountant will report on opportunities to offset current year and prior year gains with your losses. These pros can help prepare the right formula for loss realization.

Understanding the parameters you and your team should use for decision-making will help.

Next Time: What to Discuss with your Advisors.

Embracing the Millennial Millionaire

Close to 200 attendees at the 2015 Distinguished Advisor Conference (DAC) at the 12th annual event in beautiful Puerto Vallarta, Mexico. The conference was packed with information and opportunities for advisors to seize, particularly in light of the new Liberal government in Ottawa and the significant tax reforms their rise to power will usher in.

I identified four major opportunities for advisors in a changing marketplace in my opening presentation:

  1. Boomers: This aging cohort represents extreme wealth and advisors can play a critical role in helping them pass assets to the next generations through estate and succession planning to secure the future of these families. However, they must manage risks to their savings due to depopulation, taxes, inflation and fees by monitoring capital encroachment with precision.
  2. Millennials: The future is here — a powerful emerging demographic has come of age. Millennials are now the largest cohort in the workplace; they want value-based and goal-based investment advice, but often feel their needs are not being met. This generation stands to inherit enormous wealth and advisors need to adapt to serve these clients effectively. They want to participate in a values-based and goals-based investment strategy.
  3. Tax Reform: The Liberals under Trudeau made a number of promises during the recent election campaign that they hope to make good on soon. There is significant tax reform on the horizon for families, tax increases for high-earning executives and professionals, and for single taxpayers whose income levels, whether at work or at death, exceed $200,000. There is an immediate opportunity for advisors to revisit conversations with these clients.
  4. Beyond the Numbers: Striving to be a trusted advisor who functions as part of a collaborative wealth management team will give you the chance to educate your clients about technical changes and evolving trends, advocate for your clients’ needs, and be a steward of their family wealth. It’s through that three-part role that advisors can enhance their value propositions and beat the threat posed by the Internet and Robo tax and financial advice.

Just a few of the other highlights from my presentation

  • Every Canadian should maximize their Tax Free Savings Account (TFSA) savings opportunities and advisors should be doing everything they can to encourage clients to participate in this tax-exempt investment, even in the face of the impending Liberal roll-back from a $10,000 annual contribution limit to $5,500.
  • Canada is a business tax haven — the best in the G7 in fact. The new government has not indicated they will make any changes in this area, so businesses will continue to be attracted to Canada and create jobs. Advisors should see this as an opportunity to help with the business with innovative financing options, as well as financial, retirement and succession planning for the business itself.
  • Corporate tax rates are being reduced from 11% to 9% by 2019, but dividends will be taxed at a correspondingly higher rate. The additional 2% tax on dividends will affect retiring business owners and their planning for exiting the business and requires year-end tax planning.
  • The aging of our population has a ripple effect on family finances, with 20% of Canadians over 45 years old currently caring for aging family members. That number will only increase in the future.
  • The proposed Liberal tax increase on the wealthiest Canadians (over $200,000 in annual income) will affect not only those with the highest salaries, but also seniors across the country. Those who have non-pension sources of income, such as RRIFs, and are the last surviving spouse will be subject to the highest marginal tax rates. Advisors can help them minimize the tax impact by maximizing TFSAs and averaging income in retirement.

The bottom line is that advisors can add real value by taking a long-term, collaborative approach to wealth management with these different types of clients and their families — across generations — to minimize the eroders of wealth and to maximize their wealth potential.

Year-End Tax Planning: Manage the Costs of Debt

It’s hard to believe that back in 1980, Canadians’ debt to disposable income level was 66%; today it is 164%, which means that households today owe more than $1.64 for every dollar of disposable income. That’s a big problem if job loss is in the future and, therefore, should be a topic of conversation for those working in industries suffering downturns and in retirement planning conversations.

One of the underlying conditions of borrowing of any kind is simple: There must be a strategy for paying back both the principal and the interest. People with multiple types of debt must also prioritize which should be paid first.

One of the most expensive forms of debt is money owed to the tax department. CRA will charge the prescribed rate of interest, plus 4% more on the taxes owed. But they will also charge the same rate of interest on unpaid penalties such as penalties for late filing, gross negligence penalties and tax evasion, all of which can multiply the cost of the original tax debt many, many times over.

CRA can also require employers to send portions of employee’s income by garnisheeing wages; the same is true of pensions. Not only can they shut down your income, but they can take away your assets. Therefore, tax debt requires immediate attention and should be paid first.

Non-deductible debt should be tackled next. This includes expensive credit card debt and the debt attached to buying a personal residence. Interest costs here are not deductible. Neither is interest paid when money is borrowed to invest in a registered savings plan like an RRSP or TFSA.

Deductible debt, on the other hand, includes the interest you pay on money borrowed for non-registered investments, as long as taxpayers can trace the use of the money to these purposes. The onus is on you to establish that the borrowed funds are being used for the purposes of earning income from a business (claim on business statement) or from property (claim on Schedule 4) or from your rental (claim on your rental statement T776).

When money is borrowed to buy securities, the investment must have the potential to produce “income from property.” If the investment does not carry a stated interest or dividend rate, which might be the case with some common shares or mutual funds, the interest costs on an investment loan may not be deductible. CRA will generally allow interest costs on funds borrowed to buy common shares to be deductible if there is a possibility of receiving dividends, whether or not they are actually received, but each case may be assessed individually upon audit.

If the investment for which you borrowed no longer exists or has substantially diminished because it has lost significant value, you may continue to write off the interest on the loan as if the underlying asset still existed. The amount considered “not to be lost” must, however, be traceable to the loan you are paying off. If you dispose of the asset at a loss, you may continue to write off the interest costs so long as the proceeds were used to pay down the loan amount.

It can pay handsome dividends to borrow for the right things: to get an education, to purchase income-producing financial assets, rental properties and homes in which tax-exempt gains accrue. However, a “Plan B” must be available if you no longer have the financial means to fund that debt.

In those cases, where would you go to repay the debt? Taking money out of a TFSA seems like a good plan: There are no tax consequences and the money withdrawn can be recontributed to the TFSA without penalty, providing reinvestment guidelines are met.

Another alternative is repayment from other tax-paid capital that is earning a lower return than the interest costs – a term deposit, for example, or a Canada Savings Bond. Another option, use your tax refund or other social benefits that are not yet allocated to another purpose.

Least attractive options include any withdrawal that generates taxes: money taken out of an RRSP, for example, or a capital asset with a large accrued gain.

Debt management is a critically important part of year-end tax planning conversations. For help, see a Tax Services Specialist and your Master Financial Advisor.