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A Stand Against Capital Punishment – Ways to Minimize Your Capital Gains Tax Bill Part 2 – Advanced Strategies

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In my first article in this series, I have hopefully whetted your appetite for ways to have your cake and eat it, too. In other words, how to best combine large capital gains with small tax bills. Today’s missive is about putting the principles laid out in that earlier article into action.

Advanced Strategies

The following suggestions will apply some of the points noted above, and, as the cherry on top, I’ll throw a few more crumbles on the table as we go that can result in even more savings:

  • Realize Gains in Your Non-Registered Accounts Strategically. Although it can be dangerous to hold onto your investments too long in some cases, as years’ worth of gains can sometimes collapse like a hot souffle in a cold kitchen when a good stock goes bad, waiting to sell when in the right tax bracket can also save a lot of tax dollars if the stars and Wall Street both align. For clients holding rental properties or large equity positions, that might mean waiting to sell until retirement or during a sabbatical year when in lower tax brackets. My example from the first article in this series illustrates the potential savings of selling when in a lower tax bracket. You might also sell off only part of an asset in a single tax year.  Assume an investor receiving full OAS who typically earns $65,000 in other income wants to liquidate a stock with an $80,000 capital gain. The following shows her tax bill if she sells it all at the end of 2019 or if she sells 50% on the last trading day of the year and the remainder on the first trading day of 2020, assuming the price and tax rates don’t change. As tax brackets are indexed, this investor might actually save a bit more by using this strategy than this example illustrates.

Scenario                      Total Gain       Taxable Gain  Total Income   Tax Bill on Cap Gain 

Single Year Sale           $80,000             $40,000              $105,000            $15,751

Split Year Sale              $40,000 / yr     $20,000 / yr        $85,000 / yr       $13,904 (combined)

By waiting one trading day to sell the remaining 50% of her shares, this investor could save as much as $1,847, including the OAS clawback amount. Some investors might even stagger the sale over 3 years to have more of the gains taxed in even lower brackets. Just keep in mind my souffle metaphor from earlier when trying to get too clever about picking the time to sell – I don’t want you getting egg on your face by holding the stock just a little bit too long and watching your capital gain turn into a capital pain.

  • Realize your Company’s Capital Gains Strategically, too.To begin, consider whether your company’s total taxable passive income for that year will exceed $50,000 (remember – only 50% of capital gains are included as passive income, which means you can earn twice as many cap gains than interest and investment dividends inside your company for this calculation) and by how much. The federal government and most provinces give a preferred tax rate on the first $500,000 of active business income per year, with this threshold reduced by $5 for every $1 your company’s passive income from the previous year exceeds $50,000. After estimating that year’s taxable investment income, then determine how much business income you expect to make and keep in the company next year. If you don’t plan on keeping any excess earnings in the corporation or if that money would still qualify for the small business rate, then no big deal. On the other hand, if triggering too many gains might impact your company’s active business tax bill in the year to come, then decide whether or not it still makes sense to sell or see if there are any capital losses you can apply or create to reduce the taxable gain.

Conversely, if you will have already lost your small business rate next year (i.e. you’re going to have more than $150,000 in passive income this year regardless of what you do), consider turning lemons into lemon tarts by triggering additional capital gains now. By gorging yourself on capital gains this year, you might find it easier to stay under the $50,000 threshold in the future.   This works best if you have a legitimate need to re-balance your portfolio anyway or where planning on realizing the gains over the next year or two in any event, as triggering tax bills earlier than necessary means having less money to compound going forward. You would have to compare the future tax savings to the lost growth and income on the money you’re paying to the government ahead of schedule in taxes. Ultimately, since there are a lot of factors to consider, including how much realizing extra gains now might impact your personal income, the decision when to trigger corporate capital gains is usually best made with the help of your accountant or an experienced financial planner.

  • Consider Investing for Capital Gains Corporately to Protect an Active Company’s Small Business Tax Rate. My last bullet explains how too much passive income inside one of your companies can increase the tax rate you pay on active business income the following year and leave you with that queasy feeling that often follows dinner at a smorgasbord.  In addition to strategically realizing gains and losses inside your company, consider whether it makes sense to focus on capital gains investments inside your company in the first place if the passive income rules are cramping your lifestyle, as well as your stomach. Only 50% of the gains are included in the passive income calculations and you can control when you trigger those tax bills when you own individual stocks or sell ETFs or funds (although you still might receive some gains from funds and ETFs along the way.) This might work even better with investments like corporate class mutual funds (if you can stomach the fees and they still work for you after the recent tax changes that can impact their tax efficiency) that are designed to minimize taxable distributions or REITs (real estate income trusts) that generally pay tax-free return of capital in full or in part up until the time of sale. As an added bonus, your company can pay you the 50% of the total gain that wasn’t corporately taxed to you as a tax-free corporate dividend, which gets more money in your pocket without having to flow out more taxable income to you.

 

  • Use your RRSP Room Strategically.  If you’re normally in a lower tax bracket but are expecting a super big gulp-sized capital gains in the future that will push you to the tax bracket stratosphere, consider stockpiling your unused RRSP room and using it when it is time to sell. As only 50% of any gains are included as income, $50,000,000 of unused RRSP room can offset $100,000 of realized capital gains. Also, keep in mind that your RRSP contribution doesn’t have to be a long-term commitment – you can pull a bunch of the money out during the next tax year when in a lower tax bracket if you want. Have a spouse in a lower tax bracket or who might be in the future, such as if you retire in different year? Consider making the contribution a spousal one, although keep in mind that the money needs to stay in your spouse’s RRSP for at least 3 December 31’s before withdrawals can be taxed in your spouse’s hands.

Here is an example to show some of the potential savings. Assume you earn $100,000 per year net of all other deductions and make an $18,000 RRSP contribution by the end of February 2020. You have the choice of deducting your contribution for the 2019 tax year or deducting it for the 2020 year (or later, if you really wanted), as you are expecting to sell rental property with $300,000 in unrealized capital gains ($150,000 of which will be taxed) in the near future. Although you will have to wait an extra year to get your refund, here are the potential tax savings you might reap by practicing delayed gratification.

Scenario                      Total Income          RRSP Tax Refund

2019 deduction           $100,000                   $5,958

2020 deduction           $250,000                   $8,964

By waiting a year to apply her RRSP deduction, this investor saved about $3,000. Although she did lose the use of her refund dollars for 365 days, she would have needed to get an after-tax return of over 50% if getting the smaller refund sooner to make it worth her while. This investor would also definitely want to make her regular RRSP contribution in 2020, as she would have earned about $18,000 more in new room based on her 2019 income, as this additional deduction would produce a similar tax refund.

  • Consider Delaying your OAS Pension if Triggering Gains in your Late 60’s. Consider delaying your CPP as well. At this point, if your taxable income exceeds about $76,000 and you are on OAS pension, you will lose fifteen cents per dollar your taxable income exceeds this amount. Since only 50% of capital gains are taxed, think of any capital gain that takes you into the clawback zone as costing you seven and a half cents instead. Actually, it will cost you less than that as well, since you would have had to pay tax on those lost pennies and dollars in OAS pension anyway. Since you can control when you start your government pensions and are rewarded for waiting by getting an increased pension, consider delaying at least your OAS pension if you are planning on triggering a big capital gain in your late 60’s until the year after the dust has settled. This gain may have cost you your entire OAS pension for the year of sale anyway, so you really haven’t lost anything by waiting, although still get a larger pension for life. To me, it’s like trading in a kale salad for a chocolate brownie or swapping something that I won’t touch anyway for something even better down the road.
  • Consider Claiming a Capital Gains Reserve When Selling Real Estate. It’s a lot easier to spread out the capital gains hit when selling RBC shares rather than a studio apartment on Howe Street. On the other hand, there is a special rule that applies if you don’t receive your real estate or business sales proceeds in single year. In fact, if you defer enough of your gain, you can spread the tax hit out over up to 5 years. It usually means taking back a mortgage when you sell, which is admittedly something that doesn’t work for a lot of us. If selling in December, at least consider structuring the deal so that the gain is spread over 2 years rather than just one by delaying payment of part of your sales proceeds until January. If you and a spouse own real estate jointly and you don’t plan on selling for a few years, it might even be possible use this strategy between spouses before selling to an outsider. One spouse sells his interest to the other but gets paid (and taxed) over the next 5 years in 20% increments, charging his spouse interest at the minimum allowable rate during the interim. Although the buying spouse still has to pay tax on her gain plus the increase in value on the portion she acquired from her husband, the total tax bill might still be a lot less than if the selling spouse had to also include his part of the gain in a single tax year.  This is another strategy to discuss with a tax or planning pro in advance, as there are a few moving parts involved.

 Conclusion

Hopefully, some of the ideas described in this article have provided you with plenty of food for thought. If so, stay tuned until next time when I serve up the final course.

A Stand Against Capital Punishment – Ways to Minimize Your Capital Gains Tax Bill Part 1 – Basic Principles

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When the rubber hits the road and it’s time to sell your investments, all that really matters is what you have left after tipping the tax man, regardless of whether your goal is to fund a once-in-a-lifetime trip, buy your first home or merely pay for groceries. After all the hard work of saving in the first place, managing your investments and minimizing excess fees along the way, failing to do proper tax planning is like forgetting to serve whip cream with pumpkin pie – not a disaster, but still enough of a setback to cause some mild discontent and feelings of what could have been.  Adding sound tax planning on top of a great investment strategy is the icing on the cake that can make a big difference to your after-tax rate of return. This is part 1 in a three part series designed to do just that. Today’s offering focused on the basic principles you’ll need to know when doing capital gains planning. As always, all calculations use B.C. tax rates from the current year (2019).

The Basics

At the risk of stretching my food analogies to the breaking point, some of these ideas may not be a piece of cake to understand but putting in the time now might one day save you a lot of bread. To begin, it’s important to understand exactly how capital gains are taxed. The basics are as follows:

  • Only 50% of your total gain, net of expenses is added to your taxable income. This usually means paying at least half as much tax per dollar of capital gain compared to interest dollars. This is also true when investing inside a company.
  • Since only 50% of your total net gain is added to the mix, this means that you can earn a lot more capital gains in a set tax bracket before getting pushed into higher brackets. For example, assume an investor earns $50,000 in either interest, eligible dividends, or capital gains and $60,000 in net income from all other sources. Only 50% of the capital gains are taxed but eligible dividends are “grossed up” by 138% of their actual payment. Thus, the following chart shows how this hypothetical fifty grand will show up on your tax return for calculating your tax bill and what your total taxable income and marginal tax rate would be when this money is added to $60,000 in other income.                      

Type of Income       Taxable Amount      Total Income             Marginal Tax Rate*

Interest                     $50,000                       $110,000                     38.29%

Eligible Dividends  $64,000                       $124, 000                    40.7%

Cap Gains                 $25,000                       $85,000                       31.0%

*This column lists the combined Federal and B.C. tax bracket that this taxpayer would inhabit on his last dollar of total income. It DOES NOT show the actual tax rate (s)he would pay on that dollar if it was dividends or capital gains, even though it does provide this information for interest. For capital gains, (s)he would pay 15.5% on that last dollar and for eligible dividends, (s) he would pay 18.88%, ignoring any OAS clawback.

  • Capital gains are only taxed when the investment is realized or sold, unlike interest or dividends, which are taxed yearly upon receipt. That means that more of your money is left to compound most of the time when compared to other sources of taxable income, except if receiving dividends in the lower tax brackets, where the payments may be free or even better. Of course, as Moneysaver readers know so well, these dividend payments generally go along with investments that are also realizing capital gains anyway, which is like ordering a pie and getting the ice cream on the side for free.
  • You can often control when your capital gains bill is triggered, such as when selling rental property or those Tim Horton’s shares you’ve been sitting on for years. That means triggering your gains strategically can reduce how much tax you pay on your capital gain. For example, assume you have the choice of selling your rental property, which has an unrealized capital gain of $400,000 on December 31stin a year where you’re earning $110,000 in other income and one day later, after you’ve retired and expect to earn only $30,000 that year from other sources. Here is what your tax bill on the gains looks like in both scenarios:

Sale Date     Total Cap Gain      Taxed Gain     Total Income   Tax on Gain                                                                                                                  

Dec 31            $400,000                   $200,000           $310,000            $93,449

Jan 1               $400,000                   $200,000           $230,000            $76,956

But what if this investor owned the property jointly with their spouse who was also making $30,000 and they both sold on Jan 1? In that case, their combined tax bill plummeted to $62,802!

  • You can apply 50% of any capital losses you’ve realized in the past but not yet written off against gains you realize that year. If realizing any losses this year, after offsetting them against that year’s gains, you can carry them back against gains you’ve earned in the 3 prior years or carry them forward indefinitely to use against future gains or against other income if any are still on the books at your death.
  • When selling only some of a fund or individual stock in a non-registered account, while hanging onto some until later, the tax bill gets calculated by averaging all of your purchases of that asset so that you are taxed proportionately, rather than looking at each sale or purchase individually. Thus, if you sell 40% of your shares in a restaurant fund in your non-registered account, you would include 40% of the total gain of all the shares you own, regardless of when you purchased them.
  • Capital gains inside your RRSP and RRIF are like all your other RRSP and RRIF investments – taxed as income only upon withdrawal or death. Capital gains inside your TFSA are tax-free in all instances, just like any other type of income earned inside that account. That means there are no special rules for capital gains in these instances. If transferring shares you own in your non-registered account to a registered account, you trigger capital gains at that time as if you’d sold the shares instead. It is often a bad idea to transfer shares with losses to these accounts in kind, as you won’t get credit for the capital loss. Instead, consider selling the assets and either waiting 31 days to repurchase them in your registered account (or your spouse’s name or so on) or buy a similar but not identical investment inside your registered accounts if the capital loss is large enough. I talk more about this more in my later articles when discussing the “superficial loss rules.”

Conclusion

Today’s article is merely the appetizer for the far more sumptuous main course where you can put some of these principles into action.

World Money Show – September 21, 2019

Hi all,

Once more, I will be presenting at the World Money Show in Toronto, this time on September 21th. If you’re interested and don’t live in the GTA and don’t want to splurge for a trip to T.O., you can listen and look in using your computer.

Estate Planning – Minimizing the Mess, Stress, and Excess

This presentation integrates legal and financial planning in the hopes of providing attendees with some tools to not only minimize taxes and fees at death, but also the confusion, conflict and unintended results that can arise without proper planning. Learn about why testamentary trusts can still be a vital part of your estate plan and the difference between a good Will and a great one.

 

For more info, click here:  Money Show 2019

The Devil is in the Taxable Details: Understanding Different Types of Investment Distributions So You Can Make your Money Go Further

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When the rubber hit the road, what really matters when you sell your investments or get paid along the way, it is what is left in your back pocket after you’ve paid all fees, expenses and taxes. Although making investment decisions purely for tax reasons can be an invitation to disaster, failing to take tax into account when making investment decisions or deciding the right person or account to hold that investment can also be like driving with your eyes closed. More specifically, it can mean paying our friends in Ottawa more than their fair share, as it prevents you from taking steps to minimize your tax pain in advance or making different investment choices.

Just as importantly, it can also wreak havoc for budgeting and retirement planning purposes, particularly if you’re receiving OAS or GIS payments that are affected by your taxable income. Although retirement projections are largely educated guesses at the best of times due to the number of different variables thrown together in your retirement blender, failing to properly consider how your non-registered investments are taxed can mean the difference between making an educated guess and picking random numbers out of the air. 

The Basics

I won’t say much about interest income and other types of investment income that get taxed in largely the same way, such as pension income, RRSP or RRIF withdrawals and rental income. In a nutshell, it is 100% taxable, net of any expenses you incur to earn that income, such as mortgage interest. You might get a small tax credit for earning income from a work pension or a RRIF after age 65. Likewise, you might get credit on tax paid on foreign income, but the bottom line remains you pay the most tax per dollar on these sources of income as compared to capital gains, return of capital and eligible dividends.

On the other extreme, for many Canadians in lower tax brackets, eligible dividends are the most tax efficient way of receiving investment dollars. “Eligible dividends” are those paid from Canadian public companies or funds that own such companies. In order to make them more appealing to investors, our government provides a tax credit to recipients that can actually make them better free money for some Canadian!

Let’s say the company paying the dividend originally earned $100. It would have to pay perhaps $27 in tax on this money and would only have $73 left to pay out in eligible dividends. The government wants the shareholders earning these dividends to be about in the same position as if they’d earned the original $100 made by the corporation and had the money taxed in their hands like interest or business income. To make this happen, the $73 in actual dividends received by the investor is multiplied by 1.38 for tax purposes, which equals $100.74, and the shareholder is taxed on this amount as investment income.  This amount is fully taxed just like interest.

Sound like a bad deal rather than a good one? Well, this is where the enhanced dividend tax credit comes in. To balance the scales, the shareholder who actually only $73 but was taxed on $100 also gets a credit that essentially credits him for paying the $27 dollars paid by the company in the first place, which is deducted from their taxable income.

So how is this better than free money, you might ask? Clients in lower tax brackets would have paid less than $27 on $100 in interest earnings. For example, if Bob in Vernon (I use B.C. tax rates throughout this article) had $35,000 in other income before receiving his $73 in dividends, he is in the 20.06% tax bracket. Since the company paying the dividend had already paid 27% tax, the government has received more in tax dollar than would have paid if Bob received $100 directly.  Accordingly, lucky Bob can now claim a tax credit of $7 (or 9.6% of $73).  The only catch is that if someone doesn’t owe any additional taxes that year or their dividend tax credit exceeds their tax bill, then the rest of the credit is wasted in most circumstances. In other words, you can use the dividend tax credit to reduce your taxable income to zero but not to a negative amount.

The other major source of investment loot is from capital gains, or from growth in the value of an investment rather than from payouts along the way. Although taxpayers in the lower tax brackets would usually want eligible dividends for the reasons just discussed, capital gains are still a lot better than interest income, as only 50% of the total increase in value, net of costs is included as income. In other words, for every dollar in gains, 50 cents is always free and the other is taxed as income like interest. Moreover, if you sell investments at a loss, you can apply 50% of the loss against current and future capital gains. If you’re so inclined, you can even go back in time up to three years and apply the losses against past gains, which might be really helpful if you were in a much higher tax bracket during those years past.

As I’ll discuss below, capital gains become more and more appealing the higher your taxable income. In B.C., if your taxable income exceeds about $148,000, capital gains are taxed at a lower rate than eligible dividends for your next dollar of earnings. Moreover, for seniors earning OAS pensions, you are probably better off making your last dollar a capital gain rather than a dividend once your taxable income exceeds about $95,000. If you’re receiving other means-tested benefits, like the GIS, be careful about earning eligible dividends as well – the 138% gross up for income tax purposes can reduce these income-related benefits far more quickly that capital gains. If in this situation, then eligible dividends might become more of a foe than a friend.

The other thing that is so wonderful about capital gains is that you only pay when you sell your investment or there is a sale inside your mutual or seg fund. That means you can control when you trigger your tax bill and that there is more money left to compound along the way. I’ll have a lot more to say about capital gains and savings strategies in my next article.

Finally, don’t forget about return of capital. Some investments, like REITs and corporate class mutual funds (depending on how they are affected by the new corporate class rules) are able to pay you tax-free dollars every year regardless of your tax bracket. For tax purposes, it’s treated like you’re receiving some of your original investment dollars back rather than any of the three other types of distributions just discussed. That means you have more money to reinvest or to spend on that new set of golf clubs since no tax is deducted from these payments along the way. There is a catch, however, as every dollar you receive in return of capital is subtracted from your original purchase price for the purpose of calculating your eventual capital gain on sale. Thus, as they say, save now and pay later. Although it could mean a spike in your taxable income in the year of sale, it can often still be worth the later pain if it means years of savings until that day of reckoning finally comes, particularly if you are able to do some of the tax planning I’ll discuss next time.

Dividends, Capital Gains and the OAS Clawback

In general terms, your OAS pension is reduced by 15 cents for every dollar in which your taxable income exceeds a set amount, which is currently around $75,000. On the other hand, as discussed earlier, 138% of the eligible dividends you actually receive are included as income while only 50% of capital gains are added to the mix. Although you still get that wonderful dividend tax credit to apply against your tax bill when earning dividend income, this credit isn’t considered for clawback purposes.

Thus, every eligible dividend dollar you receive reduces your pension by 20.7 cents (15 cents x 138%) while every capital gain dollar you get when you’re in the clawback zone only reduces your pension by 7.5 cents (50% of 15 cents). This 13.2 cent spread isn’t as significant as it first appears, since you would have lost some of those 13 cents to tax anyway, so you might only have only been out of pocket between perhaps 7 to 10 cents depending on your tax rate. All the same, this can mean that capital gains become more tax efficient for some retirees as soon as their taxable income reaches about $95,000 in B.C. for as long as they’re in the clawback zone.

The Benefits of Only Including 50% of your Capital Gains

Another huge and often overlooked benefit to capital gains is that, since only 50% of your gain is included income, you can earn a lot more of them than other types of income before having to pay tax in a higher tax bracket.  For example, assume 50-year-old triplet brothers in Terrace, B.C. each earned exactly $100,000 in 2019 from all sources, one entirely in interest, one just in capital gains and the third got paid exclusively in eligible dividends. Their results would be as follows, after grossing up the eligible dividends by 138% and including the dividend tax credit, and only including 50% of the total capital gain:

Brother/Type of Income      Taxable Income       Total Tax Payable

Interest Ed                            $100,000                     $23,053

Dividend Dave                     $138,000                     $7,765

Capital Chris                         $50,000                       $8,056

Here are some key takeaway points from this comparison:

  • Ed paid almost 3 times as much tax as Chris since Ed was forced into the higher tax brackets sooner. Thus, although it is commonly thought that investors earning interest will pay only twice as much tax than those earning capital gains, this is only true if the extra taxable interest income doesn’t push poor souls like Ed into higher tax brackets. In this case, most of Chris’ income was taxed at the lowest rate while Ed was at a level where tax rates start to get really depressing. To make matters even worse, if Ed was earning his OAS pension, he would have been well into the clawback zone, thus increasing his total tax hit, while Chris would still be cashing his full OAS pension cheques.
  • Although Dave would still pay less tax than Chris until they were both earning around $160,000 in their different forms of income, after that point Dave would fall behind quickly, as Chris would still be in the lower tax brackets while Dave would be inhabiting high tax country. Plus, over about $154,000, dividends are taxed at a higher rate than capital gains anyway. Thus, even if the brothers both had taxable incomes of $154,000, capital gains are taxed at a lower rate from that point onward anyway. Dave would pay 25.92 cents on his last dividend dollar if his taxable income was $154,000 and Chris would be out 22.9 cents on his last dollar of capital gain if his taxable income was the same.
  • Dave only paid slightly less tax than Chris even though eligible dividends are extremely tax efficient for lower income earners. If both Dave and Chris received the maximum yearly OAS Pension of $7,217.40 as of as of June 2019 on top of their other income, Dave would have actually paid a lot more tax than Chris. Dave’s total tax hit, including the clawback, increases to $14,982 while Chris’ tax bill would only increase to $10,091. This also ignores that Chris would often have control about how much and when he realized his capital gains in order to get the best possible tax result while Dave doesn’t have that flexibility.
  • It’s important to crunch the numbers for each case. I love to use the taxtips.ca website for their tax calculators, such as the following investment income calculator that also calculates the OAS clawback: https://www.taxtips.ca/calculators/invest/investment-income-tax-calculator.htm

Conclusion

At the end of the day, it’s not what you make, but what you keep that matters. Taking the time to first understand how different types of income are taxed and then applying these general rules to your specific situation can go a long way to making more informed investment decisions, reducing your tax bill and more accurately budgeting for retirement. Next time, I’ll talk about strategies you can use to when investing for capital gains to stretch those hard-won investment dollars even further.