Wealth Insights - November 2016

Wealth Insights

November 2016

Dealing with Capital Gains Taxes

Hang on to more profit by learning how to pay less

Capital gains can do wonders for the growth of your investment portfolio. The trouble? When you put money to work outside of a registered plan such as an RRSP or TFSA, odds are you'll have to share your good fortune through capital gains tax.

The good news is there are things you can do to keep more profit in your pocket.

Capital gains: the basics

Selling an investment held outside a tax shelter triggers a tax event. If the sale proceeds are greater than the asset's adjusted cost base (net of selling expenses), you have a capital gain.

Unlike regular income which is fully taxed at your marginal rate, with a capital gain you get a break. Only half of the gain is taxable. Say you sell an investment and realize a $10,000 capital gain. That leaves you with a taxable capital gain of $5,000. If you're in a 40% tax bracket, $2,000 of your gain would go to taxes. Earn that $10,000 as regular income instead and you could pay twice as much.

What's curious about capital gains is they can create a tax obligation even when you don't overtly sell an asset.

Some situations create a deemed disposition of property for tax purposes. Generally-speaking, if you transfer an asset which has increased in value to someone other than your spouse or common-law partner, it automatically triggers a capital gain. The same thing happens if you contribute assets ‘in-kind' to a registered account.

At other times, you don't have a choice. When you die, unless your property goes to your spouse via the tax-free rollover rules, assets held by your estate are normally considered sold, opening the door to capital gains tax.

More than meets the eye

Navigating capital gains can be like trying to sail around an iceberg – it's not always easy to see the full picture. Without properly planning, you could wind up paying tax you didn't expect or even lose government benefits. Here are a few areas to pay special attention to.

Investment fund distributions. If you hold mutual funds or exchange traded funds, how those investments operate can affect the capital gains you report. For example, tax slips you receive from your fund company may indicate you have capital gains to declare, even when you haven't sold any units. The explanation? By turning over assets in their funds, portfolio managers often produce taxable gains which are passed on to investors.

A fund's regular distributions, whether based on interest income, dividends or capital gains, can impact your investment's adjusted cost base, or book value. Let's say you're following a dollar cost averaging strategy and choose to use your distributions to buy more units. These reinvested payouts have the effect of raising your fund's book value which, in turn, reduces your capital gain when you sell. An exception is a return-of-capital distribution which generally has the opposite effect, lowering the adjusted cost base thereby increasing future gains.

The bottom line? When you own investment funds, pay close attention to distributions and how your adjusted cost base might change to ensure you calculate capital gains correctly.

Foreign exchange impact. When you sell a foreign investment, you must report your gain or loss in Canadian dollars. That means how the value of the loonie moves in relation to the home currency of the asset you're selling will affect your return.

If you're selling US dollar denominated assets you've held for some time, the slide in our dollar's value versus the greenback in recent years is likely to pad your gains, or conversely, shrink your losses. Currency swings can go so far as to turn a gain into a loss, or vice versa, for tax purposes.

Day trading and other ‘business' activity. Are you trading stocks all day long or working overtime flipping real estate? Watch out. If the Canada Revenue Agency decides your activity is more than just an innocent sideline, you risk having any capital gains treated as business income. That means your earnings will be fully taxable.

Clawback of OAS benefits. Recognizing a large capital gain might have unwanted side effects. If you're a retiree, in some situations the resulting boost in taxable income can cause a clawback of income-tested benefits like OAS. There's also a risk if you pay income tax by installment. Declaring an outsized taxable gain can raise the total amount you're expected to remit for the year. Unless you plan accordingly, you could face penalties for inadequate payments.

Strategies to reduce capital gains tax

If you have realized capital gains so far in 2016, or plan to do so before year-end, here are five ways to help minimize the tax hit.

  1. Harvest tax losses

    While no one likes to own a losing investment, there's a silver lining – the opportunity to claim tax losses.

    When you sell an investment at a loss, 50% of that loss – the allowable capital loss – can be used to reduce your taxable capital gains in the current year. Any losses you don't use now won't have to go to waste. You're allowed to carry them back up to three years or forward indefinitely.

    If you're hanging on to losing investments, particularly those you feel have a low likelihood of recovery, it can be a smart idea to sell and trigger losses which you can apply against realized gains, saving tax in the process. At the same time, selling losers makes capital available to purchase new investments with brighter prospects.

    There's an important caveat when it comes to tax loss selling: the superficial loss rule. If you're thinking about unloading an investment to capture the tax loss, only to immediately buy it back – don't. You must wait at least 30 days to repurchase the same security, otherwise your loss won't be recognized.

    When selling late in the year to lock in a tax loss, you must leave enough time for your transaction to settle by year-end. This makes Friday, December 23rd the last day to execute a trade on a Canadian stock market for tax purposes in 2016 (the deadline for US markets is Tuesday, December 27th).

  2. Postpone your sale

    Unlike receiving interest or dividend income, realizing capital gains is normally something you control.

    Are you looking to take profits on winning investments before year-end? Consider delaying your sale until after January 1st. Doing so will push off your tax liability for an extra year. What's more, if you're anticipating earning less income next year, there's also the possibility you'll have a lower marginal tax rate applied against those gains, saving tax.

  3. Donate securities

    If you're thinking about selling investments to raise cash to give to charity, there's a better way: donate the securities directly.

    Gifting qualifying assets to a registered charity allows you to avoid capital gains tax that would normally apply. Plus, you'll receive a donation tax credit for your gift which you can use to reduce taxes on other income.

  4. Take advantage of life insurance

    When you have a healthy investment portfolio, deemed capital gains triggered by your death can leave behind a significant tax burden on your estate for your loved ones to deal with. Rolling over taxable gains to a spouse only postpones the liability, it doesn't eliminate it. Coming up with funds necessary to settle your obligations could force your family to take on debt, drain their own savings, or sell sentimental assets.

  5. A smarter alternative? Plan ahead with life insurance.

    The right life insurance policy can provide a tax-free benefit to cover your tax bill and final expenses. This helps preserve your estate so it's your heirs who receive your legacy, not the tax man.

  6. Catch up on RRSP contributions

    Generating tax deductions elsewhere in your portfolio can help offset taxes you're assessed when selling assets that have gone up in value. One way is to utilize any unused RRSP contribution room you've stored up. How? Make an RRSP contribution out of the proceeds from your sold investments. The tax deduction you create can lower your overall tax bill, including capital gains taxes.

Get the right advice

Want to minimize capital gains tax for this year and beyond? Then it's time to see your Westminster Savings Financial Planner. We'll review your situation and explain your options, so you can pay less and save more.

Call us at 604-517-0100 or send us your question online and we'll respond to you within one business day.



The information contained in this report was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This report is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell any mutual funds and other securities. Mutual fund, financial planning and other securities are offered through Credential Securities Inc. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax related matters. Credential Securities Inc. is a Member of the Canadian Investor Protection Fund.