Tax-loss selling may be silver lining in 2008 bear market cloud
Some strategies you can follow
Jonathan Chevreau
Financial Post
Thursday, November 13, 2008
This autumn's stock market crash has produced little but bad news for most advisors and their clients. But as the end of the calendar year approaches, there may be an opportunity to salvage something through tax-loss selling.
In normal years, tax-loss "harvesting" is a subdued affair, consisting of profit-taking in non-registered accounts with equal amounts of tax-loss selling, the objective being tax neutrality after all transactions.
There are four special tax strategies advisors can deploy in a down market, says Sandy Cardy, vice-president of tax and estate planning for Mackenzie Financial Corp. Despite the heavy losses most investors have sustained this year, "the tax system can offer some relief -- and you may even get a refund of taxes paid in prior years."
That assumes, of course, that you know the rules. The basic one is that the only losses that can be claimed for tax purposes are losses that have actually been realized. Paper losses don't count, however painful they may be -- you must actually sell the stock (or units in a mutual fund or exchange-traded fund) and book a loss in order to reap any tax benefits. To constitute a loss, the Adjusted Cost Base (ACB) must be greater than the proceeds of the disposition: the liquidated securities.
Remember too that tax-loss selling applies only to taxable or non-registered portfolios. Many clients will have serious losses in their RRSPs and RRIFs as well, but there is no relief on that score. Clients will have lost both capital and precious contribution room -- arguably the best shot will be to hold on and hope markets recover. That's a conversation advisors will have to conduct with each individual client.
Another basic is that an allowable capital loss is one-half of a capital loss. "Allowable capital losses incurred in any year must first be applied to reduce any taxable capital gains (one half of capital gains) from the same year or else they are forfeited," Cardy says, "If you have no taxable capital gains, the loss cannot be used against other income."
Thirdly, if your allowable capital losses in 2008 exceed your taxable capital gains in 2008, you will be left with a net capital loss. These can be carried back and applied against taxable capital gains realized in any of the three preceding years (2005, 2006, 2007). "If you use the carryback provision you can decide which year(s) to apply the losses against," Cardy says, "Normally, however, you want to use them against the gains of the earliest of the three years first (years 2005) as the oldest carryback years expires first."
If the losses aren't carried back, they can be carried forward indefinitely into the future to reduce only taxable capital gains (or in the year of death or year preceding death, may also be applied against any form of income). "Building
Tax-loss selling applies only to taxable portfolios up some losses now to apply strategically against future gains can smooth income and reduce tax at future marginal tax rates," Cardy suggests, "Your gains can be applied as little or as much as you want each future year - you do not need to use them all at once."
Those who wish to trigger some losses for the 2008 year cannot wait till December 31st. Cardy suggests selling no later than Wednesday, December 24th to ensure the settlement date occurs in the 2008 tax year.
The mechanics of claiming a loss against a prior year's capital gain is simple. It can be done while preparing for the next tax filing season. You must fill out Form T1A, known as a "Request for Loss Carryback," and file it with the tax return for the year in which the loss arises.
Many Canadians will need to factor in the probable capital gains from the buyout of telecommunications conglomerate BCE Inc. Indeed, assuming the deal closes on or around December 11th, BCE may prove to be a capital gains oasis in a sea of losses elsewhere in portfolios. In recent months, the combination of the bear market and uncertainty whether the deal will consummate has meant BCE has been trading at a discount from the $42.75 the Ontario Teachers Pension Plan has agreed to pay. Assuming the deal goes through at that price, investors will have only two weeks to calculate their gains and trigger comparable offsetting losses in other securities. As Cardy notes in a backgrounder on the topic, such "forced dispositions" can be a wonderful opportunity for advisors and clients to discuss portfolio rebalancing.
Even without offsetting gains, absolute capital losses give investors a chance to recoup past income taxes. Cardy cites the example of a $50,000 net capital loss for 2008. Upon filing your return in April 2009, this $50,000 loss could be applied against taxable capital gains from a previous year and generate a tax refund of $23,000 in Ontario [more in some provinces] or as little as $19,500 in Alberta.
What if a client believes a losing stock may eventually recover? Here you need to be aware of the rules against "superficial losses." Tax rules deny a loss for tax purposes if you trigger a loss and acquire the identical security within 61 days (30 days before the sale and 30 days after). Best to wait 31 days and hope the stock doesn't take off -- it likely won't since tax-loss selling by others will likely keep prices depressed at year-end.
Ironically, there are no rules against "superficial gains." You can book any gain and reinvest right away, with the benefit being a step-up in ACB. That will reduce the tax bite on any future gains on the security, Cardy says.
Finally, as of the 2006 federal budget, you can avoid capital gains on some securities by donating them to charity, a strategy that may appeal to BCE investors. You can also donate-in-kind stocks that have fallen in value: you generate both a capital loss and you get a donation receipt for the fair market value of the donated stock.
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