Many key tax-saving strategies need to be set up and implemented well before Dec. 31 if you want to benefit from them in the current year. Tax-loss selling is the classic example. Basically, this is the strategy by which you sell investments that are in a losing position in order to generate capital losses that you can then apply to offset capital gains in the year. In my previous article I looked at how to determine if you need a tax loss in the first place, and how to work out whether you actually have any tax losses. I’ll conclude this series with a look at some more advanced tax loss strategies, such as the “kiddie double play” and some traps, like the superficial loss rule.
The kiddie double play
One way to trigger losses is to transfer shares of a losing investment to your kids. In fact, if you play your cards right, you could end up getting a tax-reducing double play: First, you get the tax loss itself from the flip; then, once your kids own the investment, future capital gains can be taxable in the child’s hands, often resulting in little or no tax because they would likely be in a lower tax bracket than you. In other words, you get to claim the tax loss, and when the investment recovers in value, the capital gain could be tax free.
Here’s how it works: Every Canadian regardless of age is legally entitled to the Basic Personal Exemption, which covers off the first $11,635 of income (for 2018). And with the 50% inclusion rate on capital gains, kids can now earn over $22,000 of capital gains annually without paying a cent of tax. After your kids run out of personal exemptions and the like, they are taxed in the lowest tax bracket (assuming they have no other income). Note that your losses can’t be used to shelter your child’s gain.
In the case of minors, remember that the strategy applies only to capital gains. If dividends or interest are paid after the flip, the general rule is that you must pay tax on this income until the year in which the child turns 18 (due to the attribution rules).
To make the transaction legal in the eyes of the tax department, make sure the investment is transferred to a separate account for the child. It’s a good idea to have a written agreement to back up the flip, especially if your broker insists that the transfer be made to a so-called “in-trust account,” which is registered in the name of an adult. The paper should document that there has been a transfer of ownership either by way of gift or sale.
Beware the superficial loss rules!
The superficial loss rules can veto a capital loss if you’re selling on the market to take a loss, and you buy back an identical investment within 30 days before or after the sale. Although these rules are designed to counter artificial losses, they could apply inadvertently, for example if you sell and then change your mind to buy in again, maybe after the stock has dropped further.
The rules will also apply if your spouse (or a controlled company) buys back an investment within the 30-day period, but not if a child or parent reinvests. The rules apply not only to stocks but to mutual funds as well. But they apply only if you repurchase an identical asset. So, if you sell Bank A and buy Bank B, you’ll be in the clear.
If your mutual fund is down, one way to trigger a tax loss is to convert to another fund within the family, e.g., from a Canadian equity fund to a U.S. equity or money market fund. Note that tax losses can’t be claimed if the investment is in your RRSP. However, some funds have been set up so that, when this conversion takes place, no gain or loss is recognized for tax purposes (of course, the idea behind this type of structure is to defer capital gains). This should be checked out with your advisor, investment dealer, or the fund company before you make the conversion.
Remember that for open-market trades, the date of the tax loss is the settlement date, not when you tell your broker to sell. On Canadian stock exchanges at least, this is three business days after the trade date. Therefore, in order to claim a tax loss in 2018, the trade must actually “settle” by December 31, 2018. If you’re looking to wait for the last minute to trigger losses, be sure that you don’t miss the last possible settlement date (what with all the holidays at the end of December). Check with your broker on when you should actually enter the sell order so that the transaction settles by Dec. 31. Different rules may apply in the U.S.; and if the transaction is a “cash sale” – that is, payment made and security documents delivered on the trade date – you may have until later in the month.
Watch foreign currencies
When assessing whether you’re in a loss position, don’t forget that capital gains are calculated in Canadian dollars, so currency fluctuations can be a key consideration. If the Canadian dollar has appreciated against the currency of the investment, there will tend to be losses.
Defer your loss until next year
One example of when you may wish to pass up claiming a loss carryback is if you were in a lower tax bracket in earlier years than you expect to be in the near future, and you expect to have capital gains.
Although, capital losses can be carried forward indefinitely, i.e., to be applied against future capital gains, the further into the future your capital gain is, the lower the “present value” of your capital loss carryforward. So, if capital gains are a long way off, it might be better to apply for a carryback and get the benefit of a tax refund now, even if you were in a relatively low tax bracket.
On the flip side, if you intend to sell an investment for a capital gain around year end, you may want to defer the gain to 2019, because you can postpone the capital gains tax for a year. But note that you don’t have to actually wait until the new year to do this, as long as you sell after the year-end settlement deadline (again, check with your broker to ensure you have the correct settlement date). One exception to this strategy will occur if you expect to move into a higher tax bracket next year.
Previously published in The Fund Library on September 6, 2018 by tax and estate planning lawyer, Samantha Prasad.