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By: Mark Goodfield

2011-11-25

I would suggest that the best stock trading decisions are often not made while waiting in line to pay for your child’s Christmas gift. Yet, many people persist in waiting until the third week of December to trigger their capital losses to use against their current or prior years capital gains. To avoid this predicament, you may wish to set aside some time this weekend or next, to review your 2011 capital gain/loss situation in a calm methodical manner. You can then execute your trades on a timely basis knowing you have considered all the variables associated with your tax gain/loss selling well in advance. This blog will take you through each step of the tax-loss selling process. In addition, I will provide a planning technique to create a capital gain where you have excess capital losses and a technique to create a capital loss, where you have taxable gains.

Reporting Capital Gains and Capital Losses — The Basics

All capital gain and capital loss transactions for 2011 must be reported on Schedule 3 of your personal income tax return. You then subtract the total capital gains from the total capital losses and multiply the total net capital gain/loss by . That amount becomes your taxable capital gain or net capital loss for the year. If you have a taxable capital gain, the amount is carried forward to the tax return jacket on Line 127. For example, if you have a capital gain of $120 and a capital loss of $30 in the year, of the net amount of $90 would be taxable and $45 would be carried forward to Line 127. The taxable capital gains are then subject to income tax at your marginal income tax rate.

Capital Losses

If you have a net capital loss in the current year, the loss cannot be deducted against other sources of income. However, the net capital loss may be carried back to offset any taxable capital gains incurred in any of the 3 preceding years, or, if you did not have any gains in the 3 prior years, the net capital loss becomes an amount that can be carried forward indefinitely to utilize against any future taxable capital gains.

Planning Preparation

I am posting this blog earlier than most year-end capital loss trading articles because I believe you should start your preliminary planning immediately. (Tim Cestnick also agrees with early planning and he beat me to this topic with his article last week).

These are the steps I recommend you undertake:

1. Retrieve your 2010 Notice of Assessment. In the verbiage discussing changes and other information, if you have a capital loss carryforward, the balance will reported. This information may also be accessed online if you have registered with the Canada Revenue Agency.

2. If you do not have capital losses to carryforward, retrieve your 2008, 2009 and 2010 income tax returns to determine if you have taxable capital gains upon which you can carryback a current year capital loss. On an Excel spreadsheet or multi-column paper, note any taxable capital gains you reported in 2008, 2009 and 2010.

3. For each of 2008-2010, review your returns to determine if you applied a net capital loss from a prior year on line 253 of your tax return. If yes, reduce the taxable capital gain on your excel spreadsheet by the loss applied.

4. Finally, if you had net capital losses in 2009 or 2010, review whether you carried back those losses to 2008 or 2009 on form T1A of your tax return. If you carried back a loss to either 2008 or 2009, reduce the gain on your spreadsheet by the loss carried back.

5. If after adjusting your taxable gains by the net capital losses under steps #3 and #4 you still have a positive balance remaining for any of the years from 2008 to 2010, you can potentially generate an income tax refund by carrying back a net capital loss from 2011 to 2008, 2009 or 2010.

6. If you have an investment advisor, call your advisor and request a realized capital gain/loss summary from January 1st to date to determine if you are in a net gain or loss position. If you trade yourself, ensure you update your capital gain/loss schedule (or Excel spreadsheet, whatever you use) for the year. Now that you have all the information you need, it is time to be strategic about how to use your losses.

Basic Use of Losses

For discussion purposes, let’s assume the following: 2011: realized capital loss of $30,000 2010: taxable capital gain of $15,000 2009: taxable capital gain of $5,000 2008: taxable capital gain of $7,000 Based on the above, you will be able to carry back your $15,000 net capital loss ($30,000 x ) from 2011 against the $7,000 and $5,000 taxable capital gains in 2008 and 2009, respectively, and apply the remaining $3,000 against your 2010 taxable capital gain. As you will not have absorbed $12,000 ($15,000 of original gain less the $3,000 net capital loss carry back) of your 2010 taxable capital gains, you may want to consider whether you want to sell any dogs in your portfolio so that you can carry back the additional 2011 net capital loss to offset the remaining $12,000 taxable capital gain realized in 2010. Alternatively, if you have capital gains in 2011, you may want to sell stocks with unrealized losses to fully or partially offset those capital gains.

Creating Gains when you have Unutilized Losses

Where you have a large capital loss carryforward from prior years and it is unlikely that the losses will be utilized either due to the quantum of the loss or because you are out of the stock market and don’t anticipate any future capital gains of any kind (such as the sale of real estate), it may make sense for you to purchase a flow-through limited partnership. Purchasing a flow-through limited partnership will provide you with a write off against regular income equal to the cost of the unit and any future capital gain can be reduced or eliminated by your capital loss carryforward. For example, if you have a net capital loss carry forward of $75,000 and you purchase a flow-through investment in 2011 for $20,000, you would get approximately $20,000 in tax deductions in 2011 and 2012, the majority typically coming in the year of purchase. Depending upon your marginal income tax rate, the deductions could save you upwards of $9,200 in taxes. When you sell the unit, a capital gain will arise. This is because the $20,000 income tax deduction reduces your adjusted cost base from $20,000 to nil (there will be other adjustments to the cost base). Assuming you sell the unit in 2013 and you have a capital gain of say $18,000, the entire $18,000 gain will be eliminated by your capital loss carry forward. Thus, in this example, you would have proceeds of $27,200 on a $20,000 investment. For a more detailed analysis of flow-thoroughs including the investment risk, see this blog I wrote for the Retire Happy Blog.

One must always be cognizant of the superficial loss rules. Essentially, if you or your spouse (either directly or through an RRSP) purchase an identical share 30 calendar days before or 30 days after a sale of shares, the capital loss is denied and added to the cost base of the new shares acquired.

Creating Capital Losses-Transferring Losses to a Spouse Who Has Gains

In certain cases you can use the superficial loss rules to your benefit. As per the discussion in my blog Capital Loss Strategies if you plan early enough, you can essentially use the superficial rules to transfer a capital loss you cannot use to your spouse. A quick blog recap: if you sell shares to realize a capital loss and then have your spouse repurchase the same shares within 30 days, your capital loss will be denied as a superficial loss and added to the adjusted cost base of the shares repurchased by your spouse. Your spouse then must hold the shares for more than 30 days, and once 30 days pass, your spouse can then sell the shares to realize a capital loss that can be used to offset your spouse’s realized capital gains. Alternatively, you may be able to just sell shares to your spouse and elect out of certain provisions in the Income Tax Act. However, both these scenarios should not be undertaken without first obtaining professional advice.

Settlement Date

It is my understanding that the settlement date for stocks in 2011 will be December 23, 2011. Please confirm this date with your broker, but assuming this date is correct, you must sell any stock you want to crystallize the gain or loss in 2011 by December 23, 2011. As discussed above, there are a multitude of factors to consider when tax-loss selling. It would therefore be prudent to start planning now, so that you can consider all your options rather than frantically selling via your mobile device while sitting on Santa’s lap in the third week of December.

— The author is a tax partner and managing partner of Cunningham LLP in Toronto. This article originally appeared on his blog, The Blunt Bean Counter .

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