Oh, how ironic it is that the tax tail is waving the investment dog. Throughout most of the 1990s bull market, Canadians shared their profits with the government, paying tax at the top marginal rate on three-quarters of their capital gains on stocks.

When recent federal budgets knocked the capital gains inclusion rate down from 75% to 67% (February 27, 2000) and then to 50% (October 17, 2000), investors with non-registered or taxable portfolios realized that, from a tax point of view, the table had been tilted even more heavily in favour of stocks.

This is because interest from fixed income investments such as Canada Savings Bonds and GICs are taxed just like earned income at the top marginal rate. Capital gains, to the contrary, are now taxed about half as much as interest.

Risk a fall for capital gain
To get a capital gain, you need to risk a fall in the value of your investment. The problem is, the government doesn't share in your loss. If you earn a profit on your investment the government attacks 50% of your capital gain. If you lose money, your silent partner is just that, silent.

With today's global bear market well into its second year, many people who invest in stocks and equity mutual funds are sitting on hefty losses in 2001. However, there is a silver lining in this cloud. Those losses can be carried back three years to offset previous booked gains (and taxes paid) back during the bull market years. If you have only unrealized paper losses, investors may want to sell before year-end to realize the losses for tax purposes.

It's probably not advisable that investors wait until the last week of December to sell and make those losses official. A rally may mitigate losses, which for personal revenue is wonderful, but for taxation purposes, may be less wonderful.

This applies to investors who have been hit hard by paper losses in individual stocks like Nortel Networks, technology mutual funds, or any equity investments for that matter. By the third quarter of 2001, 80% of Canadian mutual funds were in a loss position.

Carrying back capital losses
For investors who enjoyed large capital gains in the last few years of the 1990s bull market, they may want to consider crystallizing those losses well before the end of the year. The last tax-loss trading day for Canada is expected to be December 24th and December 26th for US exchanges. This applies only to non-registered or taxable securities and portfolios.

Remember that investments inside RRSPs are not taxed on gains until the plans have been collapsed, so there is no advantage in realizing capital losses in RRSP investments. Registered Retirement Income Funds (RRIFs) are a different matter. There are compelling reasons for taking losses this year. Capital losses carried back would offset gains in earlier years when Canadian tax rates were higher.

Remember too that, apart from the lower capital gains inclusion rate, general tax rates have also been cut across the board by the federal government and most provinces. Prior to 2001, the top federal tax rate was 29%, which kicked in for income above $61,510. In 2001, the 29% rate won't apply until income hits $100,000. Below that threshold the rate is now 26%. This falls to 22% for income bands between $30,755 and $61,509. The rate is 16% for incomes below $30,755.

Assume you are in the top tax bracket. This year, as an Ontario taxpayer, you'd pay 46.4% on each additional dollar from interest or foreign income, 31.3% on Canadian dividends and 23.2% on capital gains. Now, think back to past years when you paid tax on capital gains in the bull market. In 1998 and 1999, you were effectively paying 37% capital gains tax (three-quarters of what was a top rate of almost 50%). In 2001 and beyond, however, you'd be paying only 23% (50% of today's top rate of 46%).

Carrying back capital losses from this year (or next) to prior years will therefore be beneficial. Keep in mind, though, that you can't declare a tax loss on paper losses. You have to sell a security to realize a loss for tax purposes.

Tax-loss selling
If you still want to keep a particular stock, despite a paper loss, you might consider selling it to trigger the capital loss (and get a tax refund) and then buy it back 30 days later. This tactic avoids the superficial loss rules so dear to the Canada Customs and Revenue Agency (CCRA).

If you're worried the stock price will soar before the 30 days are up then you can use an RRSP swap. If your stock was held in a non-registered portfolio, sell now and repurchase the same security within 30 days for your RRSP.

Tax-loss selling should be conducted with an eye on one's overall investment strategy and asset allocation objectives. Adrian Mastracci, President of KCM Wealth Management says, "Don't just sell something to realize a loss. Take action in context of your overall portfolio and how the individual security fits your investment plan."

Mastracci also says investors should not take into account mutual fund distributions of gains and losses, which normally take place in December. "Remember that which is most detrimental to portfolios is not incurring losses; rather it's keeping them far too long," he says.

If you turned 69 in 2001, you have until December 31st of this year to decide whether to convert an RRSP into a RRIF or an annuity. If you fail to do either, you may be liable for a massive tax liability.
 

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.