Tough year
creates planning opportunity
Stock
markets all over the globe have fallen off a cliff so far this year – and
dragged many investors along for the ride. Canadian stocks have shed about 21
per cent of their value, while U.S. and overseas stocks have sunk 14 and 19 per
cent, respectively, so far this year. While nobody likes to lose money, there
is a way investors may be able to use their losses to offset gains in other
years to ease the pain.
Capital
gains and losses arise from selling property known as “capital property”. A
capital gain (or loss) simply results from selling capital property at a price
that is greater (or less) than its original cost. Stocks, bonds, and investment
funds are among a long list of items included in the definition of capital
property.
Capital
gains and losses must be aggregated before the tax impact can be determined.
Suppose Tom ended this year with the following with respect to his capital
property transactions:
·
Capital
gains distributions from mutual funds of $2,000;
·
Capital
loss from stock sale of $6,000;
·
Capital
gain from the sale of mutual fund units of $2,500; and
·
Capital
gain from the sale of a small rental property of $4,000.
All capital
gains and losses must be “matched” together to determine an aggregate net gain
or loss for the year. In Tom’s case, he has a net capital gain of $2,500
($2,000 - $6,000 + $2,500 + $4,000). For 2001, only half of that net capital
gain is taxable – or $1,250 – at his marginal tax rate.
If we take
Tom’s case above, but assume there was no gain or loss from the sale of the
rental property, he would have a net capital loss of $1,500. Half of that,
$750, would be called an allowable capital loss.
Note that
while taxable capital gains are added to other income, allowable capital losses
cannot reduce income from any other sources. Capital losses can only be used to
reduce other capital gains. This, and the special rules surrounding the use of
losses, necessitates careful planning this year.
While net
capital losses cannot offset regular sources of income (i.e. employment income,
interest, dividends, pensions, rental income, business income, etc.), they can
be used in other years to offset taxable gains in the past or in the future.
Net capital
losses can be carried forward indefinitely. Hence, as the tax laws stand today,
a net capital loss resulting from 2001, can be used against capital gains at
any point in the future. However, net capital losses can also be carried back
three taxation years prior to the year the net loss was realized. In other
words, net capital losses resulting in 2001 can be carried back to any of the
following years: 1998, 1999, or 2000.
Suppose
Susan’s investment activity and other capital transactions result in a net
capital loss of $12,000 (allowable amount is $6,000 for 2001 and future years).
Let’s also suppose that she had taxable gains of $5,000 in each of the last
three years. Susan has three choices:
·
She
can keep the $12,000 loss to offset gains in the future;
·
She
can carry that loss back to 1998, 1999 or 2000; or
·
She
can do some combination thereof.
The capital
gains inclusion rate is that proportion of the total net gain that must be
included in income, and taxed for the year. For losses, it refers to the
proportion of total net capital losses that can be used to offset other taxable
gains. This inclusion rate has changed many times over the years, but we’ll
focus only on the years that apply to Susan:
·
1998
and 1999: 75 per cent;
·
2000: three rates applied, but let’s assume 67 per
cent was Susan’s rate; and
·
2001
and beyond: 50 per cent.
When
capital losses are carried over into other years (whether its back or forward)
the loss gets converted to receive the same “inclusion rate” that applied to
that year.
For
instance, if Susan carries her loss forward, she’ll be able to use $6,000 (the
allowable amount) against taxable gains in the future – assuming of course that
the inclusion rate remains at 50 per cent. However, if she carries the loss
back to 1998, she’ll be able to get a bigger bang for her buck because of the
higher inclusion rate for that year – allowing her to offset up to $9,000 in
taxable gains in years where a 75 per cent inclusion rate applied.
Assuming
Susan’s income hasn’t changed all that much, it becomes very apparent that
Susan should take full advantage of her ability to carry back her net capital
losses. There are two reasons for this. Not only was the capital gains
inclusion rate higher in those years, but so were the overall tax rates. Hence
there is a big benefit to carrying losses back, rather than forward, in her
case.
Without
going into too much detail, offsetting Susan’s 1998 taxable gain of $5,000
would result in a $2,400 tax refund – and she’d still have $5,333 left of her
$12,000 total net capital loss to use for other years. She would still have
enough to offset $4,000 of her 1999 taxable gain – saving her another estimated
$1,800 or so in taxes for that year.
That uses up the entire gain and allows Susan to recoup $4,200 in taxes
paid in previous years.
If,
instead, she expected a $6,000 taxable gain in 2002, she could hold onto her
loss and use it for that year. However, it would likely only save her about
$2,400 in taxes and would use up her entire $12,000 net capital loss.
By carrying
her losses back instead of forward, Susan can reap $1,800 in additional tax
savings. Further, by keeping the loss to use against 2002 gains, she will have
to wait an extra year before seeing any of her tax savings. Carrying back this
year’s loss can be done as soon as her 2001 tax return is filed – thereby
allowing her to realize the savings a full year sooner.
Individuals
planning to sell current holdings to generate capital losses will want to get
very familiar with something known as the superficial loss rules. To discourage
the selling of securities that is only meant to generate a tax benefit, the
Canada Customs and Revenue Agency (CCRA – formerly Revenue Canada) says that
superficial losses arising in a year will not be available for use in any year.
Rather, the superficial loss will be added to the cost of the property sold. In
such a case, it’s not a total loss (sorry for the pun) but it prevents the type
of tax planning mentioned above.
Tax
planning should go hand-in-hand with portfolio management in an effort to
maximize after-tax returns. Taxes can be the largest “cost” facing investors,
so any steps taken to minimize taxes while staying true to investment policy is
money in the bank.
Next
Week: The definition of a superficial
loss and how to avoid it.
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.