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tax matters

The stock market is strange if you think about it. Every time one person sells, another is buying – and they both think they're smart. Someone's losing money somewhere. Maybe you've even incurred losses. Suppose you've got realized capital losses in your portfolio and you want to use them up.

The longer your capital losses sit without being applied to reduce taxes on capital gains, the less those losses will actually save you – due to the time-value of money.

Give some thought to things you may be able to do to "manufacture" or at least expedite the realization of capital gains to help you use up those capital losses. Here are a few ideas to consider:

Sell a bond fund before the dividend.

Suppose you own a bond mutual fund or exchange traded fund that periodically distributes interest income. It's possible to convert that interest into capital gains by selling the investment before the dividend is paid to you. For example, say you buy a fund that has a $10 share price and a 6 per cent yield and goes a full year without changing in value. The fund could pay you five cents each month and keep the price at $10, or it could allow the share price to rise to $10.60 before distributing the income. In this latter case you could sell the share for $10.60 before the dividend and realize a 60 cent capital gain. Your best bet is a fund or ETF that pays a dividend less frequently – perhaps annually – because the potential capital gain will be larger than if dividends are paid, say, monthly. You can then apply your capital gains against the capital losses you have.

Consider investing in flow-through shares.

Flow-through shares are a special class of share issued by junior resource companies that give investors an immediate tax deduction. Suppose, for example, that you invest $10,000 in flow-through shares. You'll generally be entitled to a tax deduction for $10,000 in this case, with the deduction coming largely in the first year, and the small balance generally in year two. This will save you $4,500 assuming a marginal tax rate of 45 per cent. Under our tax law, your adjusted cost base (ACB) in the shares will be deemed nil in this case. The result? You'll have a guaranteed capital gain later when you sell the shares. These capital gains can be applied against any capital losses you have. I should caution you that flow-through shares are a very risky investment; although the tax savings are attractive, you've got to feel comfortable with the risk of the specific shares you're buying before you go this route.

Invest for returns of capital.

Certain mutual funds are designed to make distributions regularly that are characterized as a "return of capital" (ROC). A ROC is not taxable when it's received because, as the name implies, it's considered to be a return of your original investment. A ROC will reduce your ACB in the investment you've made. The result is that a sale of that investment later will often trigger a capital gain. This is good news if you've got capital losses to use up.

Transfer ownership of a second property.

Suppose you own a vacation or rental property that has appreciated in value. If you aren't planning or able to use your principal residence exemption on the property, you might choose to voluntarily trigger a capital gain by transferring ownership of the property to an adult child, parent, your spouse or someone else (if you do this with your spouse you'll need to make a special election to ensure the transaction takes place at fair market value rather than your ACB; speak to a tax pro about it). Once you've triggered the capital gain you can use your capital losses to offset it. This idea may work best where your capital losses are significant.

Complete an estate freeze.

If you have more than you're going to spend in your lifetime, an estate freeze can make sense. The idea "freezes" the value of certain assets you own at today's value. The future growth will accrue to, and be taxed in the hands of, someone else – usually the next generation. An estate freeze is often accomplished by transferring the assets you want to freeze to a corporation that you control. Although you can make this transfer on a tax-deferred basis, it's also possible to trigger a capital gain voluntarily in the process. This gain can then be used to offset capital losses you might have.

Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.