Tag Archives: Money

Saving it, spending it, protecting it… money makes the world go around.

Fall Harvest – Turn Losses into Gold?

The bad news is in, and the equity markets are up, but still down from two years ago this fall.  Investors are reeling from constant negative news, and are deeply concerned about the general state of the economy.  Some of these fears are well founded, as the world economy is going through a period where it de-leverages its market positions, and the effects will likely be a sustained global recession.  But, the prudent investor will remember that the markets will go up again, but it is still difficult to endure a portfolio loss.  It will take time to recover, but they will.

However, there is some immediate opportunity to be found, and it is not dependent on the markets.  The best way to make money right now is to take it from the taxman.  Since portfolios are generally down, you might want to take advantage of a concept known as “tax-loss harvesting.”

What is it?

Tax loss harvesting is the process of triggering capital losses to realize an immediate tax gain.  In the case where you trigger a loss in your portfolio, you have two options.

First, you can use capital losses to carry back against capital gains tax payable in 3 previous years.  So, if you have capital gains that you have paid recently, you can trigger capital losses and reclaim the taxes you have paid in the past.  At the highest marginal rate, this can mean that your current losing investments are worth as much as 23 cents for every dollar they have gone down.

Second, you can trigger capital losses and carry them forward indefinitely.  This means that you can “bank” a specific amount of capital losses and carry them forward to use against capital gains that you may have in the future.  This will allow you the flexibility to re-allocate portfolios in the future while limiting the taxes triggered upon disposition, or it could allow you the ability to take tax-free income from a portfolio through dispositions rather than through income or dividends.

How does it work?

Tax-loss harvesting can only be done in a non-registered, or taxable, account.  Transactions as described below will not work with assets held within a registered plan because you are not subject to tax on growth, and conversely, you are not able to take a benefit from capital losses.

Essentially, the point is to arrange a transaction to sell-out a position that is sitting with a significant drop in value, and then repurchase a similar holding in the same asset class.  This creates a loss, but maintains the desired asset class exposure so you don’t miss any potential upside.

In Canada, according to tax law, in order to take the capital loss, you must not reinvest in the same security for a period of 30 days.  So, assuming that you wish to stay invested, you do not want to be out of the market for a period of 30 days, specifically with markets as volatile as they are today.  This is why you sell one holding and purchase another similar one.

Mutual Fund Holders

So, let’s take for example that your portfolio holding, the XYZ Canadian Equity Fund, is down 25%.  The original cost of the funds was $100,000 – this is referred to as the “cost base.”  If you were to sell that fund right now, you would incur a $25,000 loss.  At the highest tax rate, this loss is be worth approximately $5,800 of taxes, either to be reclaimed from past taxes paid, or taxes payable in the future.

If you were to simply sell the fund and take the loss, you would have crystallized your loss, and if the market turned around, you would miss your gain on the upside.  Instead, you can sell the XYZ Canadian Equity Fund (“harvesting” your loss), and repurchase the LMNOP Canadian Equity Fund instead.  This will maintain your exposure to Canadian equity, but the two assets are different for tax purposes, so you will have gained a tax loss.

The good news for fund owners:  like it or not, most large cap equity mutual funds are essentially closet indexers (the secret is out).  So, it really makes no significant difference if you sell one company fund and buy another.  What does make a difference is the type of fund.  Do not sell a growth fund and repurchase a value fund – the return characteristics likely will not be the same.  So – do your research as far as the sector, but rest assured that broad market mutual fund managers are going to fall very close to the benchmark, making this a fairly reliable strategy for mutual fund investors.

Individual Stock Holders

For those who have specific stocks in your portfolio, the process is a little bit less ideal, but still viable.  You essentially have two options:

  • Replicate the strategy above, but instead of using funds that are similar, use stocks that are similar.  For instance, imagine that you own shares in Coca-Cola.  You could sell your shares in Coke and buy Pepsi instead.  These two companies are going to have very similar returns over the next 30 days: much of the risk in both stock prices is based largely on a global lack of liquidity, not whether people prefer one type of cola beverage over another. So, you can get out of Coke, crystallize your loss, move over to Pepsi for 30 days, and then repurchase Coke after the period has elapsed.
  • Or, you can replicate the strategy above, but instead of using funds that are similar, use an ETF or index fund to simulate the return of the asset class you have harvested losses from.  For example, you may have a holding in Bank of Montreal.  You could sell this holding, trigger your losses, and then purchase the iShares Financial Services ETF (XFN) to maintain exposure to the financial services sector.  While this is not a perfect replication of the BMO holding, you would still participate in the upside that the sector may experience while you are out of BMO for the required period.

In both the examples above, there may be fees involved for trading that should be factored in to the cost/benefit analysis.  Some brokerage houses have programs that will make a mass purchase of the losing assets in your account, and then resell them to you in 30 days – referred to as REPO programs.  These arrangements can help reduce the costs of this transaction if there are many holdings affected.

In all the proposed methods, you will note that I am not recommending one stock over another – in an ideal world, this is an impartial transaction.  We are simply trying to maintain the appropriate asset class exposure for the period following the transaction.

Best of all, this portfolio manoeuvre can create immediate value to your portfolio.  In the examples above, a $100,000 holding with a $25,000 loss will yield a $5,800 tax benefit.  On a holding that is now worth $75,000, that is an effective return of 7.73%, and can begin your portfolio as it works its way back to par.  The strategy is not perfect – it does mean more capital gains to accumulate in the future, but it may provide you with the ability to reclaim some lost taxes, and re-invest that money into the market to help ready your portfolio for market upside that will come in the future.

There’s No Place Like Home…

Believe it or not, there are people who believe that a home and a mortgage are too cumbersome to manage, and there are some financial experts who recommend that renting real estate is more beneficial than buying.

The advice is based on the assumption that real estate will not be the great investment over the next 40 years as it has over the last 40 years.

Regardless, look at the facts.  Make some reasonable assumptions:

  • First, assume that home prices only rise as fast as inflation,
  • Next, assume that your rent would be approximately equal to your mortgage payment
  • Then, assume that, instead of making a down payment, you take your down payment and invest in “the markets.”

If this was how you approached this decision, you would need an after-tax and after fees rate of return of 12.4% on your investment portfolio in order to have the same amount of equity in your portfolio as you have in your home!

Now, to be fair, you have taxes and upkeep on your home. If you assume that taxes are 1% of home value, and assume that upkeep is another 0.5% of home value, then you would still need an after-tax and after fees rate of return of 10.8%.

These rates of return, over the long term, are unachievable.  You would have to have an all equity portfolio for the entire period, and find a way to pay no tax, and still, historical rates of return show broad market equity indexes return about 10% – not enough to get you there!

Finally, one more important issue to note.  Your home is generally considered your principal residence for tax purposes.  This means that, when you sell it, there will be no tax.  So the equity in the home is yours.  If you have found a way to pay no tax on the growth of your “invested” down payment, and if you have found a way to get 10.8% to 12.4%, you will still have to pay tax on the growth eventually.

So – if the aggressive growth rates don’t turn you off, then the tax treatment might just.  Home ownership will likely remain a worthy and profitable goal.

Bet the Farm – Or Lock It In?

I was recently asked by a client whether they should re-finance their mortgage, and if so, how should they do it.

Since there is no way to predict the future, that is a difficult question to answer.  However, the most reasonable way to approach that question is to look at it from the perspective of risk.  A simple search on the internet for mortgage rates reveals that, if an individual were to choose a floating rate right now, they would only have to pay approximately 2% interest.  That means only $2,000 interest annually per $100,000 borrowed.  Not bad.  However, the real problem comes if/when interest rates go up.

The general answer (likely denial) is that the individual will switch to fixed when rates start to rise.  This is a difficult game to play, and it involves predicting the future.  What makes it even more difficult, is that it involves not only predicting the future of interest rates, but being able to do so better than the banks.  The problem with the timing of “the switch” is that the banks set interest rates partially at their discretion.  So, when interest rates are set to rise, they are most likely to raise the long term rates first (making a long term mortgage seem less appealing), and then raise the short term rates later.  This pattern means that consumers will stay in their floating rate too long, and switch too late, once the lenders have had the chance to adjust the longer term rates in their favour.

Worse, if the homeowner is making their buying decision (and affordability) based on low interest rates, it will be unlikely that a higher interest rate later will be work.  This would be like going to a tailor and asking them to give you a pair of dress pants that do not fit because you plan to lose weight before you wear them.  That is not likely, as time tends to deliver weight gain, not weight loss (sadly).  In this market, time is most certain to deliver higher interest rates, not lower (sadly).  Locking in now might appear unappealing, might mean a smaller house and/or higher payments, but might just be the most prudent decision in the long run.

So, what is reasonable?  Right now (Weds Aug 4), a google search tells us that the 10 year rate is approximately 5.0% to 6.5%.  That is an unbelievably good rate.  If you are new to mortgages, find someone who lived through 12-15% long term rates in the early 1980’s to figure out how good that is.  My advice is to make as much of the mortgage fixed rate as possible, and for as long as possible.  Here are some tips:

  • If you think you can aggressively pay down the mortgage, then figure out how long it will take you to pay of the mortgage and match the term to that timeline.
  • If you feel your income will increase in the future and you will be able to pay down more aggressively than a fixed rate term will allow, then take a potion of the mortgage fixed, and take a portion of the mortgage floating.
  • If you are convinced that rates are going to remain low for a while, then take a look at some recent history:
    • The Bank of Canada site gives loads of information about interest rates:
    • if you could negotiate a 5.5% 10-year rate, this is lower than the average 1-year rate for the last decade – the decade with some of the lowest interest rates in history
    • As recently as 2007, the prime lending rate was as high as 6.5% dropping to 2.5% in as little as 14 months.  The reverse could also happen (and has!).

Could you afford to pay three times as much interest on your mortgage within the next 2 years?

One final point – the main issue here is not that the “average” floating rate over the next 10 years will be higher than 5the fixed rate is now.  What is conceivable is that, in that time, short term rates could rise for a period that makes it unaffordable to finance your home.  You don’t have the advantage of the law of averages: as soon as your home becomes unaffordable, you may be forced to make some tough decisions (either sell, or refinance and begin a vicious circle, now with expensive long-term debt).

So, paying a higher fixed rate right now is difficult to swallow, because rates have just been so intoxicatingly low, and it appears that taking a 5.5% mortgage will cost you something, at least in the short term.  However, it is reasonable that you will not be able to make “the switch” on time, and you might get stuck scrambling to get into a fixed rate mortgage at much higher than 5%.  Remember that mortgage debt tends to take 10-20 years to pay off, if not more.  A long-term approach (with some historical context) makes some sense at this point.

The Child Care Expense Derby

find out who should really claim child care expenses on their tax returns

Can't decide who should claim the child care expenses at tax time?

My wife and I earn similar (but variable) incomes, and so each year we engage in what we call the “Child Care Expense Derby.”  We have the government to thank for that.  Every year I am a bit suprised by who it goes to (“and the winner is…”), but I am glad for the opportunity to get some tax back for the money we put into child care.  I always like to go to some handy tax calculators to figure out where I stand before tax time to see if I can predict the winner.  Here are two: my website (not very complicated), and TaxTips.Ca (more complicated).

The reason for the derby is this – we are never exactly sure which income will be the lowest until we get our employers’ T4’s, and then the spouse with the lowest income is the one who receives the benefit of the child care tax deduction.  Also, thew winner of the Child Care Expense Derby will be the spouse who contributes less to their RRSP.  The child care expenses can cause a big swing: tax rules allow expenses to be deducted in the following amounts:

  • a maximum of $7,000 per year for each other eligible child who is under 7 years of age at the end of the year; and
  • a maximum of $4,000 per year for each other eligible child (between the ages of 7 and 16).

This means that a family of three children under the age of 7 has deductions of up to $21,000 – nice work.  You could notice significant savings on your taxes, approximately a $7,000 tax savings for the average Canadian, who earns income at approximately a 30% tax rate.  The eligible child care is defined by CRA as on their website follows:

  • an eligible child care provider;
  • a day nursery school or day-care centre;
  • a day camp or day sports school;
  • a boarding school or camp (including a sports school where lodging is involved); and
  • an educational institution for the purpose of providing child care services.

Note that this is not an exhaustive list expenses, and other expenses, such as advertising for a care worker, or agency fees to find a care worker are also included.

The downside here is for a family that only has one income, or when the incomes are far apart (i.e. one high income and one low income), the deduction may not be as great that two mid- or high-income earners.  But it is still powerful.  Imagine a family with one income of $75,000 and one income of $45,000.  (Let’s say there are two children under 7, so $14,000 of eligible expenses).  The lower income spouse at $45,000 would reduce their taxable income by $14,000, using the childcare expenses as a deduction against income.  This would be a tax savings of approximately $3,300 for the year.

You should also note that this deduction gives you the exact same tax relief  as an RRSP deduction, so if you have to make the choice between who does what, don’t let the lower income spouse do any RRSP deduction until the higher income spouse has maximized their RRSP contribution.  This will ensure that the higher income spouse gets more deductions against their income, and that the lower income spouse does not put RRSP contributions in at an exceedingly low rate.  Some planning should help you avoid this.

This should help when it comes to deciding what to do about care for your kids, to help and reconcile the finances at the end of the year, and to generate some other tax benefits while you are at it.

Tax Free Savings Accounts

The government of Canada gave us Canadians another tax savings option in the 2008 federal budget that will go far in helping Canadians accumulate wealth in a tax-effective manner.  The Tax Free Savings Account is quite simple, and the features of the plan are as follows:

  • It is open to all Canadians over the age of 18, and continues for life.
  • The maximum contribution into this plan will be $5,000 per year. That amount will be increase with inflation in increments of $500 in future years.
  • There is NO tax deduction available for deposits.
  • All income and growth is exempt from taxation, even on withdrawal.
  • Unused contribution room can be carried forward.  If you make a withdrawal, the amount withdrawn can be replenished to the account in subsequent years without any penalty.
  • As with an RRSP, the plan contemplates spousal contributions without affecting the contribution room of the spouse receiving the spousal contribution.
  • TFSA can then be used for whatever purpose at whatever time. (buying a house, paying for a wedding, starting a business, etc.).

We think that every Canadian over the age of 18 should have this account. For the time being, your TFSA balance will be small, and that will limit your investment options, but it is a great place to hold any extra cash – since the account has no penalties to your “room” when you withdraw, you can move funds in and out without penalty.  And, with interest rates at record low levels, we need all the help we can get on interest savings after tax and inflation are taken into account.

Here are two strategies that you can implement in the future:

  • Lower income taxpayers: for taxpayers who are saving their money while earning a lower income, the TFSA is a better deal than the RRSP (i.e. for the spouse during maternity leave). This is because the positive effect of the RRSP deduction is less if the taxpayer has a lower income tax rate (lower tax rate = lower amount of tax back from your RRSP deduction). If an individual is in a situation where they expect to be earning more in the future, then the TFSA would be a far better choice, and the taxpayer could carry forward RRSP room for future deductions, hopefully at higher tax rates.
  • Funding Education for Adult Children: parents might consider funding more of a child’s education on the agreement that the adult child save the equivalent amount in their TFSA. This would allow the parents to take all relevant deductions and credits for funding their children’s education, and it would allow the children to begin to accumulate savings in their own TFSA. They are likely earning a very low income as a student, their contribution to the TFSA will come at a very low after‐tax cost.
  • All in all, I think that the TFSA is a good move for Canadians. If for no other reason, it simply provides you with another planning tool. If the tax benefits are not enough to persuade you, then the added planning options and flexibility should.

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