December, 2008
The Second Opinion: Tax Season: Part One
Tax Season: Part One
By Carlo Palazzo, CIM
The Holiday season is fast approaching. After the party comes the hangover—Tax Season! The good news is that what you do with your portfolio now could save you taxes in the new year.
Specifically, the recent downturn in global stock prices has no doubt left many subscribers with large unrealized capital losses. Selling those stocks at a loss (i.e. “crystallizing” the loss) is beneficial because the losses can be used to offset future capital gains. The crystallized losses can also be carried back up to three years to reduce taxes paid in those years, thereby entitling you to a tax refund. With dime-a-dozen forecasts of difficult economic times ahead, a little extra money in your pocket certainly can’t hurt.
To help you gain a better understanding of this strategy, called “Tax Loss Harvesting”, we have put together a Guide to Tax Loss Harvesting, which can be found below.
Tax loss harvesting is not the only strategy you can use to reduce taxes. Once you have crystallized losses (i.e. sold many of your stocks), you now have excess cash to deploy. Doing this in a tax-efficient manner can make big differences over your lifetime. Specifically, we recommend using ultra tax-efficient Exchange Traded Funds (ETFs) to redeploy that cash. Furthermore, if you have not already done so, you should consider asset location when redeploying the cash. “Asset Location” simply means holding your various types of investments in the most tax-efficient account. For most people this simply means putting your fixed-income investments inside your RRSP/RRIF/LIRA and your equities in your non-registered account.
Given the upcoming tax season, in addition to our Guide to Tax Loss Harvesting, we focus this issue on Warren MacKenzie’s tip #59 Realize That Income Tax is Your Biggest Expense. Below you will also find an important notice from the Canada Revenue Agency about a scam that is currently circulating—don’t become the next victim!
Guide to Tax Loss Harvesting
By Carlo Palazzo, CIM
Introduction
Tax Loss Harvesting is a popular tax-reduction strategy in which stocks are sold at a loss and that loss is used to offset gains. The stocks are generally sold near the end of the year, and then replaced after an appropriate period to avoid the superficial loss provisions.
The Applicable Legislation
You have a capital loss when you sell a stock for less than its adjusted cost base plus the expenses involved in selling the property. This capital loss can be used to offset capital gains (you have a capital gain when you sell a stock at a profit). However, the loss can only be used to offset capital gains. It cannot be used to offset employment income or any other form of income.
If there are any capital gains in the year, the capital loss must be used to offset those capital gains. However, if the capital losses exceed the capital gains, or if there are no capital gains for the year, than you may carry the net capital loss back three years or forward indefinitely.
The form required to carry back the capital loss is called Form T1A, and can be found here. For losses on stocks, fill out section III (or have a qualified professional do it for you). Capital losses can also be carried forward indefinitely, however, it is generally advisable to carry back the losses as far as possible.
Example
On January 1, 2005, Sarah bought 1,000 shares of ABC Company at $10 per share, for a total cost of $10,000. Now, in December of 2008, the stock is trading for $6 per share. Sarah’s position is now worth only $6,000. She decides to sell the stocks, thereby “crystallizing” her loss of $4,000. Since capital gains are only half taxable, only half of this amount (called the “allowable capital loss”) can be used to offset her taxable capital gains.
Since Sarah’s portfolio has been hit hard by the financial crisis, she has no realized capital gains for 2008. She has an option; she can either do nothing and use her $2,000 allowable capital loss next year (assuming she has taxable capital gains next year), or she can fill out Section III of form T1A to carry the loss back to 2005 (or 2006 or 2007) when she paid tax on $5,000 worth of capital gains. (Note: it is wisest to carry back the loss as far as possible as she might have an opportunity to offset gains in 2006 and 2007 next year, but this year is her last chance to offset gains from 2005).
Sarah makes the wise decision of carrying her loss back to 2005. In 2005, her tax liability looked something like this:
| Capital Gain | $5,000 |
| Taxable Portion | $2,500 |
| Tax Payable (at 30%) | $750 |
Now, in 2008, with the inclusion of her capital loss, she has this:
| Capital Loss | $4,000 |
| Allowable Portion | $2,000 |
| Tax Return (at 30%) | $600 |
Her capital loss has been turned into a $600 tax refund.
Redeploying Cash
In the example above, Sarah sold her stocks for $6,000. She also received a $600 tax refund, for a total of $6,600 in cash. However, this extra cash may not be called for in her asset allocation. Her asset allocation may call for the cash to be redeployed.
In redeploying this cash, a good idea would be to use Exchange Traded Funds (ETFs), which are generally considered to be income-tax efficient. In addition, they also carry low fees and outperform nearly all mutual funds.
Furthermore, in redeploying the cash it would be wise to consider asset location. Asset location refers to holding your different investments in the most tax-efficient account. For most people asset location simply means holding their interest-bearing investments inside their RRSP/RRIF and holding their equity investments in their taxable account.
Avoiding Superficial Loss Provisions
The superficial loss provisions are designed to prevent abuse of the above mentioned capital loss provisions. Specifically, it prevents someone from selling a stock to claim the capital loss only to replace that stock.
If someone sells a stock at a loss, but they also buy that same stock either 30 days before or 30 days after the sale, than the capital loss on that sale is termed a “superficial loss” and is not deductible from capital gains (i.e. there is no tax benefit to superficial losses). In order to avoid superficial losses, you should wait at least 30 days after you sell a stock to re-buy it. Alternatively, you can invest the money in a different stock or an ETF without waiting 30 days.
Tip #59: Realize that income tax is your biggest expense
by Warren MacKenzie
Why this is important: Sometimes we do not pay enough attention to saving on income tax because we think further reductions are impossible. But many investors overlook simple income tax planning strategies that can significantly reduce the amount of tax they have to pay.
In addition to recognizing a problem, you should also understand its impact. This applies especially to income tax. If you are paying more than is absolutely required, you may be extending your working life by several years.
Given reasonable assumptions regarding earnings and inflation, most Canadian families will pay between $2 million and $3 million of income tax in their lifetime. This is probably more than the amount they will pay for food and accommodation put together. Those with high-paying jobs will pay more than $5 million in income tax. Considering that most Canadians will retire with less than $1 million in retirement savings, these are huge amounts. Most people who save even 10% of the tax that they might otherwise pay will be able to retire a few years earlier.
By using sensible income tax planning strategies, most people with investment income can increase their after-tax return by 10%. A good start to minimizing tax is outlined in the following chapters. As well, there are other ways to reduce tax.
You should read some of the excellent books on income tax planning. I think one of the best is Tim Cestnick’s The Tax Freedom Zone. It is easy to read and covers all the important bases. Another excellent book is Kurt Rosentreter’s 50 Tax-Smart Investing Strategies.
Most investors don’t pay attention to tax-planning opportunities, or note which investments are most income tax efficient. They don’t read articles on income tax or ask questions. Simply by focusing on income tax, by making it a priority, and by asking questions, you will become aware of tax-saving opportunities. If you take the defeatist attitude that there is not much you can do about income tax, you may, over a lifetime, pay thousands, or even hundreds of thousands, of additional dollars in tax.
Caveat: Don’t buy an investment solely to save on income tax. All investments should make sense and be able to stand on their own merits. However, within the universe of investments that do stand on their own merit, choose the ones that save the most on income tax. It is the after-tax return that counts, not the gross return.
Bottom line: We pay a staggering amount of income tax. By reducing the amount that you pay, you may be able to retire years sooner. Ask your accountant to provide an independent assessment of how efficient your investment portfolio is on an income tax basis.
What you can do now: Read Tim Cestnick’s book: The Tax Freedom Zone.
CRA Issues a Warning
The Canada Revenue Agency (CRA) has issued a Tax Alert regarding a scam that is currently circulating. The scam arrives in the form of a letter or email telling the recipient to update their personal information, including banking information. This information can be used to steal your identity, which can then be used to empty your bank accounts and max out your credit cards.
If you receive this letter (or some variation of it)—do not reply to it, it is a scam!
