It’s Kim’s birthday this week. Kim is a friend of ours who’s losing it. When I say losing “it” I’m referring to her money. It’s no secret that the equity markets took a big hit last quarter, and many Canadians like Kim are facing capital losses as we near the end of this year. So, for Kim’s birthday, I’m giving her tax advice that I hope will ease the pain of losses in her portfolio for 2011. Let me share these year-end tips with you today.
Losses against gains
As we near year-end, consider selling some of your investments that have dropped in value. This makes great sense if you’ve realized capital gains this year or reported capital gains on your tax return in the last three years (on your 2010, 2009 or 2008 tax returns). Selling a loser today will trigger a capital loss that can be applied against any capital gains this year, or in one of the three prior years.
If you can’t apply your losses against gains this year, you have the choice as to which year you carry the losses back to (use Form T1A for this purpose). It makes most sense to carry the losses as far back as possible (that is, you wouldn’t generally apply your 2011 capital losses to capital gains in 2009 until you have already applied the losses to 2008 if you had gains in that year).
What if you have a loser in your portfolio but no capital gains this year or in the past three years? In this case, ask yourself whether you still like the investment. If you like the future prospects of the investment, consider holding onto it and not selling before year-end. Why? If you’re right about the investment and it appreciates in value you will have saved yourself transaction costs by not selling today. If the investment remains below your cost you can always sell it later to apply against capital gains at a later date when you have some gains.
If you have losers in your portfolio but no gains against which to apply these losses, take a look at your spouse’s portfolio to see whether he or she has any capital gains. If so, there’s a way to effectively transfer your unrealized capital losses (losses on paper) to your spouse. (If you’ve already sold the investment this idea may still work if you realized the capital loss in the last 30 days.)
Consider Kim’s example. Kim owns shares in XYZ Corp. worth $30,000. She paid $50,000 for the shares. Kim is not able to apply this $20,000 capital loss to any capital gains of her own. Her husband, Andrew, reported a capital gain of $20,000 last year. Kim wants to transfer her $20,000 unrealized capital loss to Andrew so that he can carry it back to last year and recover the taxes he paid on his capital gain.
There are three steps to make this happen. Step 1: Kim will sell her XYZ shares on the open market for $30,000. She realizes her capital loss of $20,000. Step 2: Andrew will purchase the same class of XYZ shares on the open market within 30 days of Kim’s sale (assume at the same value of $30,000). The result? Kim’s capital loss is denied to her under the superficial loss rules in our tax law (if you sell an investment at a loss and then you – or someone affiliated with you, such as your spouse – repurchases that same security in the 30 days following, or prior to, your sale, then the loss is denied).
The good news? Kim’s loss does not disappear forever; the taxman is willing to show some grace here. Her denied loss is added back to the adjusted cost base (ACB – the cost amount) of the newly purchased securities. Our tax law makes this happen automatically. So, Andrew’s ACB is not the $30,000 he paid, but is $50,000 (the $30,000 he paid plus the $20,000 denied loss). Now, when those newly acquired securities are sold, there will be a smaller capital gain, or larger capital loss, due to the higher ACB.
Finally, Step 3: After 30 days has passed following Kim’s sale in Step 1, Andrew will sell his XYZ shares on the open market for their value of $30,000. Since his ACB is $50,000, he’ll have a $20,000 capital loss to apply against his $20,000 capital gain. Presto: Taxes are saved.