Advisor analysis – Yogesh Bansal

Doug and Jeff are a typical example of clients who have been burned by investments in the past. They want to play it safe now. But they must look to the future. The good news: in the short term, at least, they will probably be able to claim some of their investment losses to get a tax break.

Note that, before any loss can be claimed at all for tax purposes, the loan or guarantee must be established as a bad debt. Since the restaurant has gone under and doesn’t expect to open its doors again, Doug and Jeff’s investment meets this criterion.

I’m assuming that Doug and Jeff used non-registered funds to make their investment in the restaurant, given the fact that their TFSA is at $32,000 each (the maximum) and it’s unlikely they would have chosen to withdraw the money from their RRSP. If the couple cashed in any equity mutual funds or stocks to fund the restaurant investment, they would have triggered some capital gains at that time, which they may be able to write off against the capital losses from the restaurant investment.

The key thing: how the restaurant investment was set up. If Doug and Jeff were involved in a partnership with the restaurant owner, they might be personally liable for any debts the business owes to creditors. But on the flip side, any of the losses they sustained will be considered an ‘allowable investment loss’ and can be deducted from their employment income for tax purposes. They don’t have to claim all those losses at once, but they can go back only three years, so they should probably cash in any capital losses as soon as possible.

We also need to determine how much of those losses are associated with Doug and how much with Jeff, as well as how the write-offs are going to affect each man’s marginal tax rate. The aim should be to get the maximum tax refund possible. For instance, there might be a scenario where the first $20,000 would save Jeff 43%, but the next $5,000 would save him only 35%. In that case, he might want to hold onto that last $5,000 and look at using it next year.

The caveat: it will be a year later by then, and Jeff can carry the loss back only three years (although he can carry it forward indefinitely). He’ll have to ask himself whether there will be enough capital gains to offset the loss if he waits. Note, however, that Doug and Jeff don’t actually have to sell stock or mutual funds to trigger capital gains. Simply switching from one mutual fund to another would do it.

At the end of the day, then, their $175,000 loss is really not $175,000, when you consider the after-tax impact. That’s not to underestimate the emotional and financial blow of the loss. It has taken away almost two years’ worth of their savings (minus the tax benefit they will have due to the loss). Still, Jeff and Doug need to understand that, given their time horizon, they have good potential to grow their investments.

If they insist on only holding fixed income products, such as bonds and GICs, they must understand that these are fully taxable in the year earned unless they are held in registered accounts. Instead, I would encourage them to venture into equity funds in their non-registered accounts; in part because they offer more opportunity for growth, but also because dividends and capital gains are more tax favorable. In fact, Doug and Jeff would have to have some capital gains if they were going to write off capital losses from the restaurant venture.

If Doug and Jeff are adamant that security is their prime motivation, I would also talk to them about segregated funds that offer a guarantee of principal, while still providing an opportunity for growth. The couple has to understand that there’s a cost associated with that security in the form of a higher management expense ratio, but it would at least be a better option than GICs. Once they see some growth in the seg fund, they might be willing to look at other options, such as a mutual fund of blue chip stocks.

In conclusion, Doug and Jeff need to sit down with their financial advisor so they can fully understand the impact of their investment loss on their financial position. Once they’ve recovered from this bad investment, they can look forward to the future in the most effective fashion.

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