A Stand Against Capital Punishment – Ways to Minimize Your Capital Gains Tax Bill Part 3 – More Advanced Strategies
If you’re not full to bursting with ideas on how to save on capital gains tax after my first two servings in this feast of ideas, today’s offering will hopefully round things off nicely. Here are some more strategies that you can consider for minimizing your family’s capital gains bill.
- Trigger and Use Capital Losses Strategically. Although some people call November and early December “autumn”, we financial types think of it as “tax loss selling season.” That’s when investors look to sell some of their losing investments to create a loss they can use to offset again capital gains they’ve earned that year and then either against any of the three prior years or against any future gains if any of the loss still remains. Here are some specific things to keep in mind when doing this:
- The “superficial loss rules” prevent you from claiming your loss if you or your spouse buys back the same stock or fund within 30 days before or after buying or selling your loser. It also catches you if either of you buys back those stocks in a different account, such as an RRSP or TFSA, or even in a trust or corporation you or your spouse control. Moreover, if repurchasing in a registered account, the outcome is even worse. It means losing your right to claim that loss forever, as you cannot claim your loss now and you don’t generate gains or losses inside of registered accounts, which means you won’t get to claim it later, either. Accordingly, if you still like the investment’s long-term prospects but want to trigger a loss now, consider waiting and re-buying after the deadline expires or buy a similar but not identical stock or fund asap if you’re not willing to wait.
- Sometimes it is possible to have the superficial loss rules work for rather than against you, such as when a spouse with no capital gains or in a lower tax bracket is the one that owns the loser investments. If the high-income spouse buys that same dog stock within 30 days before or after the low-income spouse sells it and then waits a full 30 days after that point before selling herself, then the high-income spouse will be able to claim the capital loss.
Here is a quick example of this: Jack owns a stock in his non-registered account worth $10,000 which he bought for $25,000 and is in a far lower tax bracket than Jill, who has some big capital gains to report that year. If Jack sells his stock on April 1 and Jill buys that same stock in her non-registered account on April 2 and then sells it herself on May 5, then she will be able to report a capital loss of about $15,000 on her tax return, although Jack won’t be able to do the same.
- Consider tax loss selling for its own sake when you have big losses on the books and have similar stocks or investments you could purchase with the sales proceeds yearly. Even you don’t have any immediate capital gains to realize down the road, it’s nice to lock in some of your capital losses when you get a chance and if doing so makes investment sense. Having losses on the books gives you more flexibility in the future, such as allowing you to re-balance your accounts without triggering gains, can also mean avoiding big tax bills in years you’re in higher tax brackets. If you still love the stock, then there is nothing to stop you from buying it back so long as you stay clear of the superficial loss rules.
- You have no choice if you have capital gains already earned that year when realizing losses – you have to first apply the losses against that year’s gains. Accordingly, be careful about your timing when selling winners or losers if your ultimate goal is to apply the loss against gains you’ve earned in past years or expect to earn in the future. For example, if expecting to sell a rental property at a big gain next year and this might push you into the highest tax bracket, either avoid selling your losers until next year or be sure not to trigger capital gains this year that would use up those losses.
Here is a quick example of some potential savings. Assume an investor with $80,000 in taxable income, including a $40,000 capital gain (i.e. $20,000 in taxable gains), has the choice to offset that gain this year by applying unused losses from the past or selling an investment with a $40,000 capital loss or triggering / applying that loss next year when he is planning to sell his rental property when his total taxable income, including $200,000 in taxable capital gains (i.e. $400,000 in total gains) is expected to be $250,000.
|Total Income||Total Income
Net of Loss
Tax Saving from
|Loss claimed in 2019||$80,000||$60,000||$5,640|
|Loss claimed in 2020||$250,000||$230,000||$9,960|
Thus, by waiting until 2020 to apply the capital loss, this canny investor has about 77% more money to spend on nice dinners out.
- Check to see if you have unused capital dividend credits on your small business before triggering capital losses. Capital dividends are dollars your company can pay out to you tax-free and represent the 50% of previously realized capital gains that weren’t taxed corporately. Unfortunately, if you haven’t already used up that room, 50% of future losses can reduce the amount of money you would have otherwise been able to pay out tax-free. Thus, do declare and pay out your capital dividends every year, even if you keep the money invested corporately so you don’t end up with egg on your face in the future when reporting future capital losses.
- Donate and Repurchase Your Stock Market Darlings Instead of Gifting Cash. As I explained in my recent articles on charitable gifting, if you donate appreciated stocks, the government forgives your capital gain but still gives you credit for donating an amount equal to the stock’s value at the time of the gift. If you love the stock, there is nothing that stops you from repurchasing the stock using the cash you would have otherwise donated instead. Thus, the charity gets the same gift you originally intended, you still own the same amount of your favourite stock, but the prior capital gain on that stock has now been erased. See my previous articles on personal and corporate donation to learn more about this strategy and how to use it most effectively, particularly when deciding whether to gift personally or corporately.
- Pick the Right Person to Own the Right Investments. As illustrated in some of the examples I’ve laid out in this series, there is a lot of money to be saved when gains are realized when you’re in lower tax brackets. One simple way of saving is having the lower income spouse own the investments with the bigger upside if (s)he is likely to be in that bracket for some time to come. If that spouse doesn’t have as much money to invest, consider having the higher income spouse pay more of the family bills so that the lower income spouse has the money to invest in that stock or real estate purchase that you’re sure will double in 5 years. In some cases, the right person may not be a person at all, but a trust that names both spouses and all your dependents that you control. As I’ve done with some of my clients, the wealthier spouse loans money to the trust at the prescribed government rate (currently 2%). Each year, you can decide how to distribute income and gains from the trust amongst everyone you’ve named as a beneficiary. If that includes minor children, university students not earning a significant income, or even older children that are in tax brackets a lot lower than yours, there is a lot of money to be saved. Although the lender has to declare that loan interest each year for tax purposes, which does have to be taken into account when crunching the numbers to make sure this is right for you, the trust does at least get to write off the interest. I’ve written about these trusts previously if you want to check out my website or comb the Canadian Moneysaver archives.
Finally, those of you with minor children can also consider setting up in-trust accounts for your young ones. Regardless of their age, all capital gains will be taxed in their names not yours, although dividends and interest would be taxed in the name of the person funding the in-trust account in most cases, with a few exceptions. Be careful when considering this option, however, as once the money is in an in-trust account, it belongs to the child. Once (s)he reaches the age of majority in their province of residence, (s)he can ask for the money with no strings attached!
- Own the Right Investments in the Right Account. Not only is there money to be saved when lower income family members are the ones triggering those big capital gains, there is more tax to be avoided if those gains are held in the right account! Unfortunately, many Canadians use their Tax-Free Savings Accounts as “high” interest savings accounts that perhaps pay 3% interest if the stars align just so. Instead, consider holding your investments with the biggest upside inside your TFSA and your “high” interest savings accounts on the outside looking in. Although you will have to pay tax each year on your token interest, this can be more than worth the sacrifice if it saves you mountains of capital gains tax if your TFSA investments pan out. Just be aware that if they don’t, you won’t be able to write off the losses against capital gains.
Secondly, realize that any gains inside your RRSP will be 100% taxed upon withdrawal. Thus, it might make sense to have more of your tax efficient investments, like those that pay eligible dividends and produce capital gains owned in your non-registered accounts and more of the interest-payers inside your RRSP. Although you should consider keeping the same overall investment allocation, you could essentially swap capital gains payers in your RRSPs or RRIFs for interest payers in your open accounts, although this is not a universal rule.
Thirdly, as I’ve written about before, it might make sense for some of us to pull money from RRSPs or RRIFs before we need it if we’re in low tax brackets and invest it in a TFSA or, if you have no room, your open account. Although you won’t have as much money to invest and compound than if you’d left your money in your RRSP, only 50% of your future gains will now be taxed and any eligible dividends you receive will now qualify for the dividend tax credit. There are a lot of things to consider when deciding whether to pull money out of your RRSP or RRIF ahead of schedule, so I recommend getting detailed planning advise before taking this step.
- Sometimes, the best answer is to delay, delay, delay. In some situations, procrastination is a good thing, as is sometimes the case in the world of capital gains planning. Although most of us shudder at the thought of the size of our potential tax bills at death, it might be a better choice in some instances than paying the piper ahead of schedule even at lower rates. There are a lot of moving parts in this calculation, such as how big a gain you’re facing, how long you expect to live (and ultimately pay tax at death) and the difference between your current tax rate and what you’d likely be paying at the time you’re scheduled to meet with the grim reaper. By paying tax early, you will have less money to compound going forward. Accordingly, you’ll also want to look at the expected rate of growth on your investment, too, as the higher the rate of return, the higher the opportunity cost of selling early.
The following example assumes a retiree who thinks he has 10 years to live is considering triggering a $100,000 capital gain ($50,000 of which is taxed) on a stock he originally purchased for $20,000 which averages 7% growth per year. I’ll assume it doesn’t earn any dividends. His taxable income is $115,000 that year excluding the capital gain. Alternatively, he could wait until death to sell that investment, at which time he expects to have a taxable income from all sources of over $1,000,000, which places him well within the highest tax bracket.
|Total Income Inc. Gain||
After-tax Portfolio at death Net of Tax
|Sell at Death||$1,000,000 +||$182,260|
Of course, when making this decision, the investor should also look beyond just tax to include important investment considerations, such as an over-concentration in one stock, his overall portfolio mix and expectations for the stock going forward. It could still be the wise move to sell off at least some of this position ahead of schedule despite tax considerations.
A sometimes-forgotten component of good investing is tax planning – figuring out how to minimize the portion of the capital gains the government takes off the table when you decide to cash in your chips and pocket some of your stock market winnings. Although it is important to ensure that you don’t let good tax planning lead to bad investment decisions – sometimes, any way you slice it, the right time to buy or sell means paying a bloated tax bill – it is also a mistake not to consider tax when making any investment decision. It’s a lot like failing to read the whole menu before ordering at a new restaurant – although you might end up making a good choice, you might have missed out on making a great one.