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Capital losses but no income to offset them against?
Advanced tax planning is the remedy.
Capital Loss Carryforward Positions
Superficial Capital Losses
Capital Loss Transfer to Spouse
My name is David. I’m 58 and have about five years until retirement. My total income after salary, bonus, stock options and investment income is about $325,000 per year. The investment income is derived from my non-registered investment portfolio which has a balance of $1,171,339.
My wife, Helen, is 59 and has not worked for a few years. Most of her savings are in RRSP accounts so she has little, if any, taxable income.
Helen previously had non-registered savings, but she made a large bet on a “can’t lose” investment that was recommended to her and it went sour – it was a total loss. As a result, she’s carrying forward capital losses of $55,715 from previous years. This is a bit of a shame, not only because Helen lost all of her non-registered savings, but also because with Helen being retired she will likely never be able to take advantage of the prior year capital losses.
We are wondering if you can help us with some tax planning. What are your recommendations?
Dear David and Helen:
Thanks for reaching out and I would be happy to help you. You two are in dramatically different tax brackets as David is in the top marginal tax rate of 48% here in Alberta and Helen, on the other hand, has no income. Don’t worry, this is not uncommon for us to see. I’m really sorry to hear about Helen’s investment loss but you are in luck as there are certainly some strategies that we can put into motion for you. My recommendation follows below.
Family Income Splitting Loan
While David is working, every dollar of income that you can shift from David’s tax return to Helen’s tax return will save you money. You would be able to use a family income splitting loan arrangement to transfer taxable investment income from David to Helen. To do this, David would transfer the majority of his taxable investment portfolio to Helen and she would invest the funds in her account where the income would be taxed at her lower tax rates. Even though David has $1,171,339 you may choose to do a $1,000,000 loan to simplify the tracking and management of it. There may be good reasons for David to hold onto some money as well (as discussed in more depth below). To satisfy the CRA’s requirements, and to avoid the income being attributed back to David, the transfer from David to Helen must be structured as a loan, with interest being paid annually. The interest rate can be set as low as the CRA’s prescribed interest rate, which is currently 2%. The interest payment must be included as income on David’s tax return, but it can be claimed as a deduction on Helen’s tax return.
It’s important to note that the transfer of investment assets from David to Helen will be treated as a deemed disposition for tax purposes, even if assets are transferred in-kind. So from a practical perspective, it would likely make the most sense to liquidate to cash rather than transferring in-kind as it would be easier to obtain details of your capital gains and losses if you actually sell the investments. This is general advice only, and if you had investments that are thinly traded or otherwise difficult to trade, or if you felt like the commissions or other fees being charged would be significant, then you may find that an in-kind transfer will work better for your circumstance.
You would want to be aware of the magnitude of capital gains being triggered for David to make sure the strategy still makes sense, and if investments are being disposed of at a loss, Helen would be wise to wait 30 days before repurchasing the same investments to not trigger superficial losses. Finally, it’s imperative that interest payments are made on the loan from Helen to David no later than January 30 of the following year.
When David retires, the suitability of the loan should be readdressed. It may be that all or a portion of the loan should be repaid to David so that you both fall into the same tax bracket throughout your retirement.
Helen’s Prior Year Capital Losses
The family income splitting loan strategy will give Helen the opportunity to utilize the $55,715 of net capital losses that she has been carrying forward from the past. With $1,000,000 of capital in Helen’s taxable investment portfolio, she’ll have the opportunity to use ongoing capital gains to chip away at her prior year capital losses each year. As a result, Helen will only be paying tax on her interest and dividend income for the foreseeable future. While staying within your overall asset mix targets, it would be wise to focus Helen’s taxable account to be more growth-focused so that the likelihood of having capital gains is higher. Each year, Helen could consider triggering the capital gains in her account.
It’s important to note that a potential unintended consequence of this strategy could result if stock markets decline. In this case, Helen would have even more capital losses – which is the exact opposite outcome of what you’d be trying to accomplish. However, if this happens there’s a way for Helen to transfer losses back to David.
Transfer Capital Losses from Helen to David by Using Superficial Loss Rules
There’s a saying, “hope for the best but plan for the worst” and I think that applies here. It’s possible that Helen could experience further capital losses in the future if her non-registered account is positioned with a significant equity component. If further losses were to occur, then Helen should look to transfer the unrealized losses to David toward the end of every year. Not only does Helen not want any additional losses, but David is in a higher tax bracket so the losses are worth more to him than to her.
To do this, Helen would have to identify her securities (stocks, bonds, mutual funds) that have capital losses in her portfolio. She could then sell these securities which would trigger the loss. If David were to then repurchase the same securities within 30 days, the superficial loss rules will kick in – but to your favour. Helen’s loss will be denied but the amount of the loss will be added to David’s adjusted cost base so that when he ultimately sells the securities his gain will be reduced accordingly.
Through a judicious process, Helen should be able to realize all capital gains for herself and transfer all capital losses to David. This should significantly accelerate the speed at which Helen is able to take advantage of her prior year net capital losses and allow her to avoid accumulating further losses in her tax records.
If you were to proceed with this plan, then you’ll have shifted income from David’s high tax rate to Helen’s low tax rate. Let’s take a look at the value proposition here:
- The $55,714 of capital gains that have been taxed by Helen would have zero taxes, due to her loss carryforwards. If the same capital gains had been taxed at David’s 24% tax rate on capital gains (24% is one half of his marginal rate of 48% on regular income) he would have had to pay $13,372 in taxes.
- If Helen invests $500,000 of the $1,000,000 in Canadian stocks yielding a 3% dividend she will have $15,000 of eligible dividend income. This income is so efficient due to the Canadian dividend tax credit that Helen, at her tax bracket, will pay zero dollars in tax on this income. At David’s top tax bracket (in Alberta) he would pay 31.7% on the same income. Shifting this income from David to Helen will save the family $4,755 per year.
- If Helen invests the remaining $500,000 in interest-bearing investments or foreign stocks that pay the same yield she will have another $15,000 of income. These types of income are taxed differently, so she will pay 25% tax on that income. David would pay 48% tax on that same income at his tax rate. Shifting this income from David to Helen will save the family another $3,450 per year.
- Offsetting these savings would be the interest payment from Helen to David for the loan. The 2% loan interest would equate to $20,000 of interest to David. At 48% he would pay $9,600 in tax. Luckily, Helen would get to deduct the same income on her return and at her rate of 25%, this would save her $5,000. The net for the family is a tax burden of $4,600 per year.
To summarize, we believe that this strategy will save you $13,372 from the capital gains as noted above, plus an ongoing savings of $3,605 per year ($4,755 + $3,450 – $4,600 = $3,605). After four years the payoff would be approximately $28,000.
Hope this helps!
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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information.