Over the past few years, stock markets have delivered both heart palpitations and an exhilarating ride. The tax-smart investor will apply tax planning principles in both the run-up of the exhilarating times and the declines of the bad times.

First, remember that all tax minimization strategies derive their success from either or both of two benefits:

  1. deferral advantage
  2. rate advantage

Deferral Advantage

Deferral advantage derives from the time value of money, which says that it is always better to pay taxes tomorrow than today.

Rate Advantage

Rate advantage derives from the fact that we have a “marginal scale” of tax rates… the higher your income, the higher your tax rate.

While the time value of money always works to your favour, marginal rate differences can work for you or against you, depending on what your marginal rate is each year.

Inclusion Rate

With capital gains, there is a third benefit, which is the “inclusion” rate. The inclusion rate in Canada has always been less than 100% for capital gains; therefore, a dollar of capital gains income is always taxed less than a dollar of all other kinds of income… employment, business, interest, rent, etc. Over the past thirty years, the inclusion rate has varied significantly, from 0%, 50%, 66% and 75%. While we haven’t enjoyed the 0% rate for a long time, today we are enjoying the 50% rate.

Tax strategizing for capital gains has several components; first, good record-keeping; second, active management and; third, clever completion of your tax return.

Good record-keeping involves keeping track of what you paid for all of your investments. For stocks and bonds, this is usually quite simple. For mutual funds, it can be quite complicated, and needs to be updated annually. It also involves keeping track of all of your dispositions in the year and keeping track of your “paper” gains and losses (“Paper” means the gain or loss on the investments that you still hold). Active management means reviewing where you stand for the year and contemplating selling an investment deliberately for tax advantage. This must be done annually by late December. Clever completion of your tax return must be done every April and involves applying capital gains tax law to your best advantage.

Strategies

At this time of year, the tax smart investor is determining whether any active management is appropriate. Step One is to figure out where you stand with all of your sales to-date. In total for all of your sales, you will be in one of three situations: a net winner, a net loser or neutral (i.e. maybe you haven’t sold a thing so far!). Step Two depends on which of these three fit your situation.

Net Winner

If you are a net winner, for starters, enjoy the fact that some of your windfall is completely and effortlessly tax-free, thanks to the inclusion rate. The next step is to estimate your taxable income from all other sources this year to determine how much tax you will pay on the taxable part of your gains. If your marginal tax bracket is low, perhaps you should be happy to do nothing and just pay the tax, which could be as low as 0-12%.

However, if your marginal tax bracket will be high on your gains, then its time to move on to Step Three, which involves finding some losses to write off against your gains. You may find losses in one of two places: your existing investments or your prior years’ tax returns. Now, some background tax law….

Net Loser

Capital loss carryover rules allow you to carry old losses forward until you die. That’s a pretty long window of opportunity!

Here’s where your record-keeping system is important. You need to review your historical records to determine if you are carrying any losses forward from any previous years. If you are, then you can offset this year’s gains merely by applying the old losses forward on this year’s return. A simple stroke of the pen on your return in April solves your tax problem!

If you don’t have any, or enough, losses carrying forward from old years, then you must work a little harder. “Tax loss” selling is a strategy promoted in the investment community and business periodicals. This involves reviewing your portfolio to flag “losers” that could be sold to realize a loss which will offset your gains to-date.

You should approach tax loss selling carefully. In failing to do so, you may fall victim to letting the tax tail wag the dog. It is imperative that you apply business and investment criteria foremost to your tax-loss decision. Tax literature writes about tax loss selling but doesn’t adequately tie it back to loss carryover rules. Here’s why…

Those same rules that allow you to carry old losses forward through an entire life time, also allow you to carry future losses back up to three years. Here is where your calm discipline goes head-to-head with urgency created by those around you, including the media.

“Tax loss selling” means selling a loser! It means finally giving up on a stock that you have held. If you believe that the stock still represents a good company whose share price currently is beat up in the market (perhaps along with all share prices, like nowadays), then selling may be a bad decision… the tax tail wagging the dog.

Your strategy instead could be to “take it on the chin” and pay your capital gains tax this year. The carry back rules imply that you can keep your thumb on this tax you paid for three years into the future. If any of those three future years finds you a “net loser”, then you will be carrying those losses back to recover the tax you pay today.

A downside to this approach versus tax-loss selling is the “present value of money”. The latter strategy saves you taxes paid immediately, while the former strategy will have you pay tax today and get it back in the future. However, if that losing stock turns around nicely, you will be more than rewarded for waiting a few years for your refund.

One more thing… the “tax loss selling” strategy can fall on the sword of one other bit of tax law called the “superficial loss” rules. This law prohibits the “having your cake and eat it, too” approach where you would sell a loser to trigger your desired loss, but then buy it back immediately, so that you still are riding the future fortunes of the company. The law prohibits you from repurchasing the stock for thirty days, and also prohibits a related party, like your spouse, from buying it, too.

If you are a net loser, the clever application of loss carryovers on your tax return also needs to contemplate the significant changes in the inclusion rate in the past few years. Losses realized to-date in 2001 can be offset either by triggering gains before the end of the year or by carrying those losses back to 1998, 1999 or 2000. The inclusion rates are 50% in 2001 and 75% in 1998-9. The inclusion rate in 2000 varies with every single taxpayer and is somewhere between 50-75%. Your own particular inclusion rate can be found in either your 2000 tax filing or the related assessment notice from the government. Thus, the value of carrying this year’s loss back to 1998/9 is greater at 75% than it would be in selling another stock this year to generate a gain.

Neutral

If you are “neutral” but have paper losses on stocks that you have given up on, it may be wise to realize the loss now if you can carry that loss back to either or both of 1998/9. Remember that in 2002 you no longer will be able to apply losses back to 1998, and similarly in 2003 for 1999. So, by 2003, the value of losses all may be at the 50% inclusion rate, depending on your individual circumstance in 2000.

Think about this as you apply active management to this year’s stock sales. Lastly, as you contemplate strategy, don’t forget your marginal tax brackets in all the years you are working with.