Choose to lose

The current investment landscape is painted red with significant accrued losses just waiting to be realized. You can help your clients make the most of these losses in difficult times by offering them some tips about tax-loss selling.

To benefit from capital losses, there must be capital gains against which to apply them. If capital gains were realized earlier in the year, any losses realized at the end of the year could provide tax savings in the 2008 return. And even if your clients are in a net capital loss position for the year, they can apply those losses to net capital gains realized in the three preceding years—2005, 2006 or 2007— and recover related taxes paid in those years.

However, even though realizing losses can provide tax benefits, the decision to sell a security should not be primarily tax-motivated. It has to make sense in relation to an investment plan and overall financial goals.

A client may say: I can sell this security now, to realize the loss, and simply repurchase next year. But that strategy involves a number of risks. First the client needs to carefully consider superficial loss rules. Under these rules, if a capital loss is realized and the same or an identical security is purchased by that person, his or her spouse or partner or by a corporation controlled by either of them, 30 days before or after the sale—and is still owned at the end of that period—that capital loss is denied and added to the adjusted cost base (ACB) of the shares owned by the acquirer. The rule also applies if the security is acquired by certain related partnerships or trusts (this includes RRSPs and TFSAs).

To avoid the loss denial, your client can wait until after the requisite 30-day post-sale period to repurchase the security and deal with the inherent risks. There is the risk that the security will increase in value during the waiting period, resulting in a higher buyback price and the transaction fees that will apply to the sale and repurchase could put a dent in the expected benefits.

Your client may also consider selling the security to a child, thereby negating superficial loss rules. But in order for the loss to be realized, it has to be a real disposition— there must be a change in beneficial ownership—and that means your client has to be willing to part with the security and actually turn it over to his or her child.

If the loss securities are fund units or shares, your client might be able to repurchase sister funds with a similar investment mix—as long as the sister fund is not considered the same security, the superficial loss rules don’t apply.

Finally, there’s an opportunity to use the superficial loss to your client’s advantage by transferring the capital loss from an individual who can’t use it to a spouse or partner who can. For example, Milly sells a security and later that day, her husband, Ray, buys the same security. Ray has net capital gains for the year. Milly’s capital loss is denied because of the superficial loss rules and added to the ACB of the shares owned by Ray. Ray sells the shares after 30 days and realizes the loss, which can be applied against the capital gains he realized earlier.

In determining the potential capital loss, it’s very important the ACB is computed properly. This can get complex if the shares were purchased over a number of years, or if there have been share distributions, or they were acquired under a stockoption plan.

Further, in the case of income funds, clients need to remember that capital distributions from the time of purchase reduce the cost base of the investment.

Finally, if you sell a loss investment and the related loans remain outstanding, although your capital has declined in value, the related interest can still be fully deductible, as long as the entire proceeds are reinvested to earn income.

Gena Katz, FCA, CFP, an executive director with Ernst & Young’s National Tax Practice in Toronto. Her column appears monthly in Advisor’s Edge.