Originally published in The Fund Library
With stock markets doing a passable imitation of a roller coaster this month, many investors will be tempted to do some year-end tax-loss selling. This is a tried-and-true way to generate tax savings for the current year, by using losses to reduce capital gains. Last time, I covered the basics of tax-loss selling. In this article, I'll look at some more advanced strategies, starting with transferring shares to your kids. In fact, if you play your cards right with this popular strategy, you could end up getting a tax reduction "double play."
First, you get the tax loss itself from the flip of shares to your kids. But in addition, once your kids own the investment, future capital gains can be taxable in the child's hands – often resulting in little or no tax payable, because your children are probably in the lowest (or at least a lower) tax bracket.
In other words, you get to claim the tax loss, and when the investment recovers in value, the capital gain, which will be taxed in your child's hands, could be tax-free! Here's how.
Every Canadian individual regardless of age is legally entitled to the Basic Personal Exemption, which in 2014 exempts the first $11,138 of income from any tax. And with only 50% of capital gains included in income, this means that 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, if they have no other income, they are taxed at the lowest tax bracket. Note, however, that your losses cannot be used to shelter your child's gains.
In the case of minors, remember that this strategy applies only to capital gains. If dividends or interest are paid after you flip your shares to your child, the general rule is that you must pay tax on this income until the year in which the child turns 18 (this is a result of the "attribution rules").
Always document the transaction
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 the transfer be made to a so-called "in-trust account," which is registered in the name of an adult. This 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, you might sell you shares, then change your mind and buy in again, perhaps after the stock has dropped further. The superficial loss rule would apply here, vetoing your capital loss.
The rules will also apply if your spouse buys back an investment (or a controlled company) within the 30-day period; however, they don't apply if a child or parent reinvests.
These rules apply not only to stocks, but to exchange-traded funds and mutual funds as well. However, they only apply if you repurchase an identical asset. So if you sell Bank A and buy Bank B, you're okay.
How to use mutual fund losses
If your mutual fund is down, one way to trigger a tax loss is to convert to another fund within the fund family, for example, from a Canadian equity to a U.S. equity or money market fund. But remember that tax losses cannot be claimed if the investment is in your RRSP.
Some mutual funds have been set up under a corporate umbrella so that when this conversion takes place there is no gain or loss recognized for tax purposes. Of course, the idea behind this type of structure is to defer capital gains. But it would negate your effort to generate a tax loss. Check this out with the fund company or your advisor before you make the conversion.
Keep an eye on settlement dates
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, this is three business days after the trade date. Therefore, in order to claim a tax loss in 2014, the trade must actually "settle" by December 31, 2014.
Different rules may apply in the U.S.; and if the transaction is a "cash sale" –payment made and security documents delivered on the trade date – you may have until later in the month.
Exchange rate risk
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 in which the investment is held, there is a greater chance that there will be losses.
When to defer your loss
You may wish to pass up claiming a "loss carryback" 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 – that is, 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 anticipated 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 off an investment for a capital gain around year-end, you may want to defer the gain until 2015, because you can postpone the capital gains tax for a year. 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. But check with your broker to ensure you have the correct settlement date. One exception to this strategy is if you expect to move into a higher tax bracket next year.
I'd like to take this opportunity to wish everyone a happy holiday season, and a healthy, prosperous New Year!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.