Don’t miss the opportunity

Between January 1, 2003 and December 31, 2007 the total return on the TSX / Composite Index increased 132 per cent.  As of the close on October 27, 2008, the Index has given back part of these profits by declining 38 per cent year to date.

Tax considerations should be secondary in ensuring your money is in the best possible investments at all times.  But when markets rise or decline significantly in a given year, it is more important to look at the tax consequences.  Tax loss selling is a term used for investors to sell some of the underperforming stocks to offset realized capital gains during the year.

In a year like 2008, the capital loss rules are important to understand.

RRSP accounts should hold your conservative investments, such as bonds and cash equivalents.  Your riskier equity positions should be held in a non-registered or taxable account.  Capital losses are only applicable to investments in non-registered and taxable accounts.  The term unrealized is associated with an investment you have bought but have not sold.  If you have sold the position it is “realized.”

Realized capital losses are generally only deductible against realized capital gains.  Realized net capital losses may be carried back up to three years and forward indefinitely.  For 2008, these rules allow you to carry realized losses back to the 2005, 2006, and 2007 taxation years.

The reason some people should consider realizing some losses in 2008 is to recover taxes paid in the previous three years under the capital loss carry-back rules.  We encourage people to look at both the fundamentals of their existing investments and look at the tax consequences to realizing any capital losses this year.

As an example, let’s use Mr. Mackenzie who purchased some stocks in a taxable account in early 2003.  Having made a nice profit, he sold some investments in 2005 generating a capital gain of $20,000.  Mr. Mackenzie also realized net capital gains of $6,000 and $4,000 in the 2006 and 2007 taxation years, respectively.  Mr. Mackenzie should review his total portfolio in 2008 to see if he can realize any capital losses in the current taxation year.  If Mr. Mackenzie had $30,000 in net capital losses, then he could carry back all of these losses to the three taxation years noted above.  If Mr. Mackenzie only has $10,000 in net capital losses he should carry this loss back to 2005 first.  Failure to take advantage of the carry-back rule fully in 2008 would mean the 2005 amount is lost.

We would encourage people to look at their tax situation early this year and gather these  four pieces of tax information:

  • Unused net capital loss carry forward information by year
  • Net capital gain information for 2005, 2006 and 2007
  • Realized capital gains or losses for 2008 from selling non-registered investments (not including RRSP, RRIF, RESP), including stocks, bonds, mutual funds, exchange traded funds, real estate, etc.
  • Listing of unrealized capital gains and losses on your non-registered investments (those that you still own and have not yet sold) by taking the difference between the current market value and the adjusted cost base.

The above exercise may appear easier than it looks.  The following is a quick list of items to factor in when looking at your 2008 tax situation and non-registered investments:

  • Mutual fund distributions or other income distributions designated as capital gains are generally included on tax slips (T3 and T5) that arrive in early 2009
  • Certain mutual fund and exchange traded fund distributions increase the adjusted cost base
  • Dividend reinvestment plans should be factored in when determining an average cost for tax purposes
  • If you hold the same security in multiple non-registered accounts you will have to calculate an average cost for tax purposes
  • Some investments have a return-of-capital component which reduces the original cost that you paid
  • Bonds purchased at a premium will create a capital loss at maturity and bonds purchased at a discount will create a capital gain
  • Investments denominated in a foreign currency should have a cost base that is converted to Canadian dollars (proceeds converted to Canadian dollars as well)
  • If you have any defunct or de-listed securities you should determine if you have previously claimed the capital loss
  • Ensure you factor in any February 24, 1994 elections that you made

The following outlines some general rules to adhere to before doing any tax loss selling:

  • Do not break the superficial loss rules.  If you are selling a security to realize a capital loss then you or an affiliated person (i.e. spouse, corporation) must not purchase the identical security within 30 calendar days.
  • Do not transfer positions that are in a loss position to your RRSP as an “in-kind” contribution as the loss will be denied.
  • Any donation of securities in-kind should be those that have unrealized capital gains.
  • Carry all current net capital losses back to the earliest year in which you have capital gains (maximum three years back).
  • Focus on quality investments rather than making decisions solely for tax purposes.
  • Eligible losses are those that “settle in 2008”.  Most investments that are sold settle 3 business days after the trade date (i.e. last day for tax loss selling on Canadian exchanges this year is December 24)

This column highlights some of the “tax” items to consider prior to “tax loss selling” or carrying realized capital losses back/forward.  If you have significant capital gains or losses, we encourage you to meet with your financial advisor and accountant and map out a plan.