Capital Ideas – How To Get The Biggest Benefit From Those Unwise Investment Decisions That Produce Capital Losses

Have you ever made any investment decisions that you’ve lived to regret? Unless your last name is Buffet or Graham (and even so, I would still have my doubts), you’ve probably purchased at least a few investments that still cause you to stare into space while ruminating on how much money you lost. Moreover, unless you are content to live with GIC investments that currently pay less than the cost of inflation net of tax or have mastered the art of seeing into the future, there is a pretty good chance that you’ll have additional mistakes to lament over in the years ahead.

While I believe that the reality that some of your investments will lose you money is just part of the cost of doing business, if you are an investor, there are at least some steps you can take when doing your tax planning in order to get some of that money back. The next few paragraphs will talk about precisely that and, hopefully, by the time you reach the end, you’ll be able to get a few more dollars flowing your way at tax time and will be able emotionally to move on to that next big investment choice.

Capital Losses - The Basics

When you finally give up the ghost and sell off your share of the Next Big Thing Inc. Inc. at $0.80 that was purchased at $4 a share, you will very likely be able to get some of your money back from our compassionate friends at the CRA. That is because 50% of the total loss (50% of $3.20 to use my example, or $1.60) now becomes a taxable capital loss that you can apply against the taxable portion (again 50% of the total gain) of the capital gains you get when you get it right. Put another way, although the CRA may not be actually giving you back any of your capital losses, they will at least allow you to keep more of your gains, tax-free in compensation.

Even better, they allow you to go back in time up to three years after you trigger your losses (i.e. sell your dog investments) if you’re willing to refile your tax returns for those years so that you can use these losses to offset the gains you reported and paid tax on during that time. Although you first have to apply your losses for the year in which they were realized, if you have any gains to report, you can choose which of the three previous years in which to claim them, which can be a huge benefit.

Don’t have any capital gains to nullify in this year or three years back into antiquity? In that case, you can carry forward these unused capital losses indefinitely until that happy time when you incur a capital gain that you can brag about to your family and friends. Moreover, if that day never comes, you can at least go to your final resting place knowing that you probably won’t have to take this unused capital loss with you: for the year of your death or for the year prior to it, the taxable 50% of your capital losses can be deducted against other sources of income rather than just against capital gains.

Before proceeding, here are a couple quick strategies to help you get the most out of your losses:

• Since you have to use up any losses realized that year against gains from the same period, be careful when you realize the gains or losses. Although tax considerations shouldn’t be driving the bus when you’re making investment decisions, if you’re in a low income year even after triggering a nice capital gain, you might hold off triggering your loss until the upcoming January if you have gains from a few years back when taxed at a higher rate. Of course, this might mean having to wait an extra year to get the money, since you can’t use the loss until the next tax year after you’ve filed a return and applied it against gains from that period. Accordingly, you’ll have to determine whether the difference in payments is worth the wait.

• As losses can only be carried back three years, consider realizing losses on some securities this year if some or all of the loss can be used against a gain from three years ago that was taxed at a high rate. That doesn’t mean you can’t repurchase the sold security if you still believe all will be well in the end. It just means that you have to be careful to avoid the superficial loss rules that I’ll talk about later.

• When deciding which year to apply your loss against if carrying back losses from years gone by, look at your marginal tax rate for that year—as the higher the rate for that year, the better off you are using the loss against that year.

• When carrying losses back, if your marginal tax rates are comparable for each of the three previous years, claim your loss against your gain from three years ago since this is the last year that you will be able to do so.

• If you’re expecting some big tax years and capital gains in the years to come, consider holding off on using unrealized losses from years past against current gains in a low income year, especially if there is a big enough difference coming soon, such as if you will be selling rental property or another big capital asset. Let's look at an example where you decide to claim your deduction in a year that you’re at a 30% marginal rate instead of two years from now when you expect to be taxed at 41% when selling an investment property. You would have to earn 16.9% after tax each year compounded to be break even. For most of us, that is well worth the wait.

• If you have huge capital losses and don’t want to wait until death to use them, take that into account when picking future investments. Investments like REITs that offer a return of capital along the way but produce big capital gains when you do sell (if you pick the right one, that is) are one option. Another is investing in corporate class mutual funds. They can convert pretty much any type of investment return into capital gains and will even allow you to withdraw some of your capital along the way without triggering gains as a “return of capital”. As a result, when you do sell these investments, such as after withdrawing all of your original capital, a large capital gain is usually on the horizon. Theoretically, if you’ve already pulled out all of your original investment, capital gains are all you would have left. If you are a real risk-taker, you could even consider flow-through shares that can ultimately translate the total amount of any investment into a capital gain. Of course, when making investment choices, always remember that no matter how tax-efficient the potential return, a bad investment is still just a bad investment.

Tax Loss Selling

Although many of us categorize December and perhaps late November as the time to get ready for and celebrate the holidays, sadly, tax planners often refer to it by a different name: tax loss season. This is because that is the time that investors with significant realized capital gains for that year often take a close look at the rest of their portfolio to see if they want to sell any of their less-than-stellar investments in order to offset some of these impending gains to reduce their impending tax pain. In fact, even for investors without a big gain that year may be tempted to sell their losers to get back some of their taxes from gains reported in any of the three years prior, especially if this is their final shot to get some money back from a big gain realized three years previously.

In many cases, however, the investors may face a tough choice, as they may be reluctant to pull the pin on some of their underperforming investments in the belief that their time to shine is yet to come. The savvy among you might ask why they don’t just sell then immediately purchase them back. That is because of something called the “superficial loss rules.” Boiled down to the basics, this means that if you (or your spouse) repurchase the same investment within 30 days after selling, whether in the same account, your TFSA, RRSP, RRIF, company, trust, etc., you won’t be able to claim that loss. Instead, the repurchased stock will be deemed to have been acquired for what you originally paid for the stock you sold, plus any transaction costs you incurred during your repurchase.

This can be a diabolical double whammy for those transferring these underappreciated gems into a registered account (or otherwise tripping up the superficial loss rules when purchasing them in a registered account). Since losses inside of registered accounts are never considered capital losses, not only has your investment declined in value from when you first executed that purchase order; you have now also ensured that you will never get the chance to write off the loss against future gains even if your investment is still underwater when you sell it inside your registered account.

Fortunately, despite the wide reach of the superficial loss rules, all is not, well, lost. Here are a few ways of hopefully having your cake and eating it too:

Consider simply waiting 31 days after selling before repurchasing your original investment and make sure you and your spouse don’t have any automatic monthly purchases of the same investment or investment fund between now and then.

Sell your loser and repurchase a similar type but not identical stock or fund immediately so that you don’t get caught with your pants down if the market rallies over the next 30 days.

Particularly alarmed about missing the boat on a volatile investment with no comparable alternative investment? If you own it in a personal non-registered account, purchase the same amount you want to eventually sell in a registered account, your spouse’s non-registered account, inside a holding company or a trust 31 days before you plan on selling. Essentially, you are doubling down for that 31-day period. When you do sell the original shares, you get to claim your loss and the adjusted cost base on the repurchased shares (if in the name of your spouse, a trust or a holding company) will be what you paid 31 days previously. Of course, you do run the risk of increasing your losses along the way if it is a bad month on the market.

Gift the shares to an adult child, as they aren’t caught by the superficial loss rules. Even better, perhaps get them to stick it in their own TFSA so if it does pick up steam, the profits will be tax-free even though you were able to realize a loss on your own tax return for the year of the original gift. (Most parents who do this find that the chances of their own children naming a child after them vastly increase.)

Finally, there is one huge silver lining that the superficial loss rules provide for married investors: sometimes triggering the application of these rules can actually work in your favour! Imagine this scenario. A high-income spouse is facing a truly scary capital gains bill that coming April while at the same time her loving husband has a huge unrealized capital loss as a result of following a stock tip he picked up while drinking scotch and playing poker a few years earlier. Although it is not usually possible for spouses to share capital losses, the superficial loss rules provides a sneaky (but perfectly legal) way to do just that.

In order to get the desired result, our unfortunate husband would need to sell that stock and his capital-loss-seeking wife would need to buy the same one within 30 days. If she then waits 31 days to sell after her purchase, then she would be the proud owner of a capital loss equal to the value at the time of her husband’s purchase plus any transaction costs related to the selling and repurchase minus what the stock was worth at the time she finally parted ways with this investment. Since only 50% of any capital loss is actually deductible against gains (just like only 50% of any gain is included in income), she can write off half of this total loss against her gains from that tax year, and can carry back any excess losses to either of the three previous tax years or carry it forward indefinitely to use in the future as described previously.

Conclusion

Although tax loss selling (and capital loss planning in general) should probably not be the entire focus of holiday season, it is probably worth at least a few moments of your time. Although none of us love to relive investment follies from the past, we can at least do what we can to maximize their tax benefits going forward. The money you save can make next year’s holidays all the brighter. Hopefully using the principle above and getting a little tax help, too, will let you do just that.

Colin S. Ritchie, LL.B., CFP, CLU and FMA is a Vancouver-base fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com