Canada: The Fund Library Publishes Samantha Prasad's "Where To Find Losses To Shelter Capital Gains From Tax"

Last Updated: August 3 2017
Article by Samantha Prasad

Where to Find Losses to Shelter Capital Gains from Tax

I recently read an interesting article on the Monty Pelerin's World website titled "The Trump Effect and Markets – Market Update." It argued that the initial "Trump effect" as it relates to the market is wearing off and is being replaced by the reality that Trump and his ideas may not be welcome in Washington.

Now, I do not pretend to know how the market works. But on the assumption that the runup after the election is starting to run out of steam, I wondered if people were tempted to start to keep their money in cash and cash-equivalent instruments. No doubt the low risk associated with such investments is hard to ignore. However, it should be worth noting that seeking safety in income-producing investments and cash may sometimes buy you a tax problem, since it may likely require you to change your investment position.

A Little Shelter from Capital Gains Tax

If you are holding stock that has an accrued gain but are convinced that it's still safer to trigger a capital gain on the sale of that stock and hold the resulting funds in cash, then here are some possible tax losses that you may be able to use to shelter from or offset the resulting capital gains tax.

Bad loans. Included here could be such items as bad mortgage investments or junk bonds (or even a no-good advance to your company, bad loans to a business associate, and so on.).

To obtain a deduction, the loan must generally be interest-bearing. So, if you made a loan to a relative on an interest-free basis, for example, the Canada Revenue Agency (CRA) can take the position that the loan was not taken out for income-earning purposes and therefore no loss is available to begin with. An exception to this arises if you are a shareholder of a Canadian corporation and have advanced the money to it on a low- or no-interest basis. In this case, provided that certain conditions are met, the CRA will give you at least a capital loss on the bad loan.

When is a loan bad? The government's position is that claiming a bad-debt loss on a loan is basically an all-or-nothing proposition: The whole of the loan must be uncollectible; or when a portion of the debt has been "settled," the remainder must be uncollectible. Also, the party line is that either you must have exhausted all legal means of collecting the debt, or the debtor must have become insolvent, with no means of paying the debt.

* Out-of-business companies. Another overlooked source of tax losses is investments in companies that have gone bankrupt or are now worthless because of insolvency and the cessation of business activities. This may often include a company that has been delisted from a stock exchange.

Note: If a bad investment is in a Canadian private company that was engaged in active business, the loss could qualify as an "Allowable Business Investment Loss" (ABIL). If so, this type of loss can be deducted against any type of income, whereas a normal capital loss can be deducted only against capital gains. Word of warning: If you claim an ABIL, assume that you will receive a standard letter from the CRA asking for information to support your claim.

* Bonds purchased at a premium. If you have invested in a bond (i.e., outside your RRSP), it is possible that you purchased it at a premium over its redemption price because the coupon rate on the bond itself was higher than comparable interest rates when you bought the bond. In these cases, there will probably be a capital loss at maturity, or if you have sold it.

* "Last chance" capital gains election. Check your 1994 return to see if you have made the "last chance" election to take advantage of the now-defunct $100,000 capital-gains exemption. For most investments, this will result in an increase in the cost base of the particular item, which in turn will reduce your capital gain; however, that also assumes that you have held the particular investment since before 1994. If your gain is on a mutual fund, and you made the election on it, you may have a special tax account – known as an "exempt capital gains balance" – which can be used to shelter capital gains from the fund.

* Check your carryforward balances. Check to see whether you incurred capital losses in a previous year that you have not yet used. This is quite possible, because deductions for capital losses can be claimed only against capital gains, and unclaimed capital losses can be carried forward indefinitely. If you don't have records, another idea is to contact the CRA to request your personal carryforward balances.

* Have your kids report capital gains. If an investment is owned by your kids, the gain can be reported on their tax return. This could dramatically slash – even eliminate – the tax bite. Here's why: Every Canadian individual – irrespective of age – is legally entitled to the basic personal exemption, which covers off the first $11,474 of income (for 2017). And with the 50% capital gains inclusion rate, this means that kids with no other income can now earn just over $22,000 of capital gains annually, without paying a cent of tax.

Even if the gain exceeds this amount, since your kid pays tax on the gain in the lowest tax bracket, the tax rate is significantly lower than that of a high-income earner. (Note: if the parent funded the child's investment, the parent must normally pay the tax on interest and dividends generated by the investment until the year the child turns 18, unless a prescribed loan strategy was put in place – more on this in my next article.)

Sometimes, people hold an investment for their kids, e.g., as a gift for them, but register it in the name of the adult. This isn't necessarily a show-stopper. For one thing, if the account is registered in your name "in trust," this may show that it is really for your kids. A tax advisor may also suggest the possibility of documenting the fact that the investment is for your kids, e.g., by filling out a legal declaration of trust. Of course, this is assuming that there originally was a gift to the child.

* Defer with reserves. If you sold an investment for a capital gain, but you are not entitled to receive the cash proceeds until the end of the year, you are allowed to defer a portion of your capital gain until next year by claiming a "reserve." Basically, reserves may enable you to defer your tax on capital gains over a five-year period.

* Sell off losers. If you are looking to getting out of stocks, there's a chance that for every stock that has an accrued gain, you probably have another stock that is sitting in a loss position. So simply engage in tax-loss selling – sell off some of your losers to trigger some losses to offset your gains.

Previously published in The Fund Library on ​July 20, 2017.​​​

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.

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