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Time for tax planning
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

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.

    Capital loss planning

    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.

    Superficial loss

    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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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