Turn losses into lemonade

Investment advisors generally don’t aim to generate capital losses. That said, strategically realizing capital losses and using them to a client’s advantage can be a prudent approach.

The TSX posted large gains in 2009 (31%) and 2010 (14%), but is off about 8% year-to-date at the time of writing. Stocks like RIM and Suncor are down considerably more than the overall markets.

If a client had taxable capital gains in 2009 or 2010, they might consider realizing losses in 2011 to carry back and offset previous capital gains. Taxpayers can carry capital losses back up to three years from the current taxation year to generate refunds of taxes previously paid.

For some clients, the process is reasonably straightforward. They have losses in their account; they had gains in the last three years; so they sell stocks today and generate tax refunds next spring when they file their tax returns.

For others, it’s a little more complicated. Their spouses may have losses in their accounts, but no previous capital gains to offset. Or maybe they’re in a much lower tax bracket and the losses aren’t as valuable to them.

Whatever the reason, there are ways to transfer losses between spouses, but you have to be careful about how you do it.

One option is to have spouse A (the one with capital losses) sell their shares and realize the loss. Spouse B (who wants to use the loss to offset gains) then buys the same number and class of shares within a 30-day period. The shares must then be held for at least 30 days, after which, assuming they still trade at a loss, spouse B can sell them and realize the loss personally.

The relevance of the 30 days is that if spouse B buys the same shares that spouse A sold within a 30-day period, spouse A’s capital loss is denied for tax purposes. Spouse A’s original cost becomes the new cost on the shares for spouse B, despite the fact spouse B actually bought the shares at the lower current market price. Spouse B must wait 30 days to sell to avoid being hit with the same loss denial under a CRA provision called the “superficial loss rule”.

But what if spouse B doesn’t have any cash available to buy the shares? He or she can consider “borrowing” the cash proceeds from spouse A on the initial share sale and documenting this with a simple loan document. Technically, the borrowing spouse (spouse B) needs to pay interest back to the lender spouse (spouse A) at a minimum of 1% interest rate as prescribed by the CRA for the duration of the loan (a minimum of 30 days). The interest received is taxable to spouse A and deductible by spouse B.

A little creativity with tax planning is a great way to show your clients you’re going above and beyond to serve their needs. It’s also a great way to say you’re sorry for the capital losses, even if the ebbs and flows of stock markets are more to blame than you! It’s always worthwhile to reach out to clients and their tax advisors as the end of the year approaches.

Tax planning is an important component of financial planning—and an important component of the comprehensive wealth planning clients are looking for these days. It’s a lot easier to do the little things required to keep an existing client than to go out and find a new one.