Tax strategies in a down market

Given the market conditions over the past few months, there’s a good chance that many of your clients are faced with investment losses in their portfolios. The psychological fallout of the whipsawing markets has continued to drive down the value of both good and bad stocks, so just about everyone is facing sizable losses in their portfolios.

You may be telling your clients to hold on, which is sage advice, but there may be some opportunities to trigger losses for tax benefits. While nothing makes up for losing money, the tax system can offer some relief, and your clients may even get a refund of taxes paid in prior years.

Basics of tax-loss selling

The only losses that can be claimed are those that have been realized and where the capital gain calculation produces a negative amount, that is, where the adjusted cost base is greater than the proceeds of disposition. So your clients’ first decision is whether they wish to sell some of their underwater stocks. If they do, in order to have the tax benefit apply to the 2008 year, they will have to sell by no later than December 24 so that the settlement date occurs in the 2008 year.

Secondly, an allowable capital loss is one-half of a capital loss. Allowable capital losses incurred in any year must first be applied to reduce any taxable capital gains (one half of capital gains) from the same year, or else they are forfeited. If your clients have no taxable capital gains, the loss cannot be used against other income.

Third, if your clients’ allowable capital losses in 2008 exceed their taxable capital gains in 2008, they will be left with a net capital loss. Net capital losses can be carried back and applied against taxable capital gains they had in any of the three preceding years (2005, 2006 and 2007). If your clients use the carryback provision, they can decide which year(s) to apply the losses against. Normally, however, they should first use them against gains in the earliest of the three years (year 2005), as the oldest carryback year expires first.

If your clients decide not to carry these losses back, they can be carried forward indefinitely to reduce only taxable capital gains (or in the year of death or the year preceding death, they may also be applied against any form of income). Building up some losses now to apply strategically against future gains can smooth income and reduce tax at future marginal tax rates. Your clients’ gains can be applied as little or as much as they want each future year — they do not need to use them all at once.

How to claim the loss

The mechanics of claiming a loss against a prior year’s capital gains involve filling out Form T1A “Request for Loss Carryback,” and filing it with the tax return for the year in which the loss arises. The rules allow your clients to decide which year they would prefer to claim the loss against. But if they don’t use it against the 2005 year and they had taxable capital gains in that year, they will lose the ability to use that year for future losses, since it will be outside the three-year period.

Cash from tax losses

A loss in portfolio value provides investors with a chance to recoup income. Consider a client with a $50,000 net capital loss for 2008. When your client files his/her tax return next April, and assuming this net capital loss has been applied against taxable capital gains from a previous year, it could result in a tax refund as high as $24,000 (in Nova Scotia), $23,000 (in Ontario) or $19,500 (in Alberta).

Claiming a loss on a stock you think will recover

What happens if your client sells a stock at a loss, but you believe the stock will recover and thus recommend that they buy it back? In this case, your client must be aware of the superficial loss rule. This provision of the Tax Act states that if you sell securities at a loss and you, your spouse, your RRSP, or a corporation controlled by you or your spouse acquires the identical property within a 61 day period (30 days before the sale and 30 days afterward), you are denied the use of the loss. However, the amount of the loss denied is added to the cost base of the identical securities purchased. The usual advice is to sell the stock, wait 31 days, then buy it back and hope that no upward price move has taken place. Selling stocks only to buy them back after 30 days may be risky, but in this market, it is likely that December will be faced with more downward pressure on stocks as traditional year-end selling drives markets down.

Triggering capital gains

Despite the downward spiral of the markets, you may have clients who still own winners in their portfolio. They may consider selling one or more of these to generate realized capital gains, which can be offset by losses on other stocks that they would like to sell. They may reinvest right away in those winner stocks, as there is no income tax rule preventing them from doing this, in contrast to the superficial loss rule on realized capital losses. By implementing this strategy, your clients receive a step-up in their adjusted cost base, which will reduce future gains.

If your client doesn’t have unrealized losses, but the spouse does

The superficial loss rule discussed above can actually be used to shift the benefit of accumulated unrealized losses from one spouse to the other. The recipient spouse of that unrealized loss can now create a realized net capital loss (if allowable capital losses exceed taxable capital gains for the year) and carry this back to any one of the three preceding years or carry it forward. For more details on this strategy, please read our Mackenzie brochure on Tax Loss Selling or BCE Tax Minimization Strategies.

Restructuring debt

If your clients have debt on which interest is not tax deductible (such as a mortgage or debt incurred for personal expenditures), they may consider selling some losers in their portfolio and using the proceeds to pay off the debt. Afterward, they can re-borrow to replace the investments sold (or a greater amount of debt, within their omfort zone). Because the borrowing costs are now directly traceable against investment income, your clients have essentially converted non-deductible interest to deductible interest.

Donating stocks

Most investors are aware of the benefits of donating stocks that have increased in value, since any accrued gain will be tax free — the federal budget of 2006 reduced the inclusion rate to zero on in-kind-donations of qualified investments.

Conversely, clients can consider also donating in-kind stocks that have decreased in value — they will generate a capital loss and the client will also receive a donation receipt for the fair market value of the stock donated.

Sandy Cardy is vice-president of tax and estate planning at Mackenzie Financial.