Tax loss selling and how it works

If you have a regular (non-RRSP and non-RRIF) mutual fund account, here is a tax tip that could save you money or even recover significant amounts of tax from a prior year tax return.

In some instances, it may be prudent to generate a capital loss to offset taxable capital gains for the current tax year or even to recover tax by going back three tax years and obtaining a tax refund.

Although this will likely be a down year for most mutual funds and fund distributions may be fewer overall, some mutual funds may still pay out a capital gain and you will receive a T3 slip. If however, you did some tax planning and triggered sufficient capital losses before December 31, you can offset the capital gain tax bill, perhaps to zero!

If you do not have any capital gains this year or in the last three, the capital loss can be carried forward indefinitely and applied to any future capital gain – minimizing any future capital gains taxes.

How do I trigger a capital loss for tax purposes?

For tax planning purposes, the idea of “crystallizing” a loss often entails a sale of the investment and a purchase of something else.

You can do this a number of ways, however, we have to be mindful of short-term trading penalties and CRA tax rules about buying back the same investment within 30 days of selling it.

One of the best ways to keep your investment strategy intact and generate tax savings at the same time is to switch your mutual fund into a corporate class mutual fund. The corporate structure for tax purposes means that you are switching into a different fund and therefore, you can claim a capital loss merely by switching. The 30 day rule does not apply to switching to a corporate class mutual fund.

If corporate class funds are not available for your particular fund, you may also consider switching to a similar mutual fund in the same mutual fund family. The 30 day rule does not apply in this case either.

With careful planning, triggering a capital loss can be accomplished without incurring any additional costs and can recover significant amounts of taxes.


Tax-Free Savings Accounts (TFSA)

Beginning January 1, 2009 anyone 18 years of age or older can take advantage of a new savings vehicle that is entirely tax free.
You have the option of choosing savings accounts, GICs, mutual funds or any other investments you currently hold.

Unlike conventional RRSPs, contributions are not deductible from your taxable income; however, any withdrawals that you make from a TFSA are tax free.
Investors can withdraw funds from a TFSA at any time for any purpose and not be taxed or otherwise penalized.

Investment income (including capital gains) earned in a TFSA is not subject to tax.

You will be allowed a maximum contribution of $5000.00 per year and again any withdrawals that you make can be reinvested the next year.
As well, any unused contribution room can be carried forward indefinitely

If you have a spouse, both of you can have your own TFSA.

Individuals can transfer investments from an existing non-registered account into a TFSA, however be careful about transferring investments at a loss.
For instance, you will not be allowed to claim a capital loss if you transfer shares directly to a TFSA.

Instead, sell the shares for cash and then buy the shares back within the TFSA. By doing it this way, you will be able to claim a capital loss for tax purposes.

“My fund has dropped in value and I have received a T3 tax slip - why do I have to report fund distributions on my income tax return if I’ve lost money this year?”

From the client’s viewpoint, he believes that the T3 just adds insult to injury. Why would he have to pay tax on something that has dropped in value?
This question is quite common and sometimes the best explanation is the simplest.
In client presentations I have often used our homes and houses as examples to help explain how mutual funds work.
I’ve changed it a bit to make it specific to the client’s taxation question:
“You’ve bought a second house in town as an investment. Naturally, you’ll want to rent it out to cover your unavoidable costs (MER?) that you will incur – things like property taxes, upkeep, repairs, etc. Unfortunately, the real estate market has temporarily gone down in value and the property is worth less than what you bought it for. Although you know that you’ve lost money on your purchase (on paper), you still have to declare the rental income on your tax return whether or not the house has gone up or down in value.”

This same sort of rule applies to mutual funds that generate investment income throughout the year. Some mutual funds can consist of dozens of individual stocks, some of which pay dividends throughout the year. Dividends along with any interest income and capital gains are all taxable items.

If however, you have a mutual fund in a RRSP or RRIF, everything is tax sheltered and mutual fund distributions are neither reported nor taxed.

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