My kids love to read.
"Dad, what's the most creative work of fiction you've ever read?" my son, Win, asked.
"Son," I replied, "I'd have to say your uncle's tax return would be at the top of the list."
Unfortunately, Uncle Charles is no longer with us, but he did suggest in his last days that tax planning would have been a good idea. So, let's go with that advice.
I've been talking about the four pillars of tax-smart investing: (1) control the timing of income, (2) control the type of income, (3) control the location of income, and (4) control the offsets to income.
Today, I want to finish off by focusing on pillar number four: Offsets to income.
What I'm talking about is creating deductions or credits to offset income earned, or tax that might otherwise be owing, on your investment portfolio. The most common types of offsets include capital losses, charitable donation tax credits, interest deductions, foreign tax credits, losses from limited partnerships, business expenses in some cases, and other deductions, such as flow-through share deductions.
Try the following ideas to reduce your tax using offsets:
1. Argue that it's a business
If you're actively trading in securities, you may be able to argue that your profit should be taxed as business income rather than capital gains. Now, only half of your capital gains are taxable, so don't be quick to make this argument. Having said this, if you do report your profits as business income, you'll be entitled to deduct many types of expenses against your income, including many things you may be paying for anyway, such as a portion of mortgage interest, property taxes, and similar expenses. See my article dated April 22, 2010, for more.
2. Donate securities to charity
Since 2006 it has been possible to eliminate the tax on capital gains on specific securities by donating those securities to charity. Normally, the capital gains inclusion rate is 50 per cent (meaning that one-half of your gains are taxable), but the inclusion rate is set to zero if the securities are donated to charity. In addition to zero tax on the capital gains, you'll be entitled to a donation tax credit for the value of the securities donated.
3. Harvest capital losses wisely
As we near year-end, many Canadians will choose to sell some of the losers in their portfolio to realize the capital losses, which can then be offset against capital gains that might have been realized this year, or in the three prior years (2013, 2012 or 2011). This can make good sense if you have capital gains this year or in the past to offset, or if you simply don't like the investment any more.
4. Track your cost properly
If you're investing in mutual funds, be sure to add the amount of any taxable distributions each year to your adjusted cost base (ACB) of the investment. If you fail to do this you'll end up paying tax twice on the same growth in value.
5. Claim foreign tax credits
Don't forget to claim a foreign tax credit for foreign taxes paid on income you're reporting on your Canadian tax return. You may also want to avoid dividend-paying foreign shares in your Tax-Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP) or other registered account since you won't be able to claim a foreign tax credit for foreign taxes withheld on income inside those plans.
6. Avoid the superficial loss rules
If you sell an investment at a loss and you, or someone affiliated with you (your spouse or a corporation you control, for example), acquires or reacquires that same security in the period that is 30 days prior to your sale, or 30 days after your sale (a 61-day window), your capital loss will be denied. The loss isn't gone forever; it will be added to your ACB of the reacquired securities, so that you'll eventually realize the tax savings from that loss when you ultimately sell those securities.
7. Choose your funds wisely
If you invest in mutual funds that have unused capital losses, future capital gains in that fund could be partially sheltered using those losses, which can result in higher after-tax returns for you.
8. Deduct interest costs
It can make sense to borrow to invest if you do this prudently. Interest on money borrowed to earn income can generally be deducted, offsetting some of your investment income, and providing tax savings.
Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.