I often come across investors who are reluctant to sell an investment because of the associated capital gains tax payable. Whether it’s a stock or mutual fund they’ve owned for ages, a rental property that has appreciated considerably or a business they have built from scratch, the payment of capital gains tax may be a strong deterrent from selling an investment.
Let’s consider three scenarios and look at some of the options available to investors.
Stock or Mutual Fund
When someone holds an old legacy stock from an employer they used to work for or shares they inherited years ago from a parent, I often ask them: if you had that money in cash today, would you buy that stock today? If the answer is no, that’s a good reason to consider selling it. I’d rather see people holding investments on purpose than by accident.
Let’s imagine a scenario where someone owns stocks with a purchase price or adjusted cost base (ACB) of $20,000 and the market value is currently $120,000. They have a massive $100,000 unrealized capital gain. At most, if our investor is in the top marginal tax bracket in Nova Scotia, they could be paying 27% tax to sell. Chances are, with a modest income from other sources, they’d be paying more like 20% tax depending on their province of residence.
A $20,000 tax hit would take a big chunk out of their investment capital. A $120,000 investment would turn into only $100,000 after-tax. How much higher a return would one need to earn over the subsequent 10 years to come out ahead? The answer: approximately 2% annualized. And what about over a 20-year period? About 1% each year.
Earning an extra 1-2% on your investments may or may not be easy. But in certain cases, it may be easier than you think, especially if your capital gain isn’t as large as my extreme example.
Do you have unused RRSP or TFSA room for which the proceeds can be used as a contribution? If an investment you’re thinking about selling has large capital gains, you could possibly put the money to better use in a tax-sheltered or tax-free environment. These tax incentives may offset, in part, the tax disincentive of incurring the capital gain in the first place.
Is the stock you’re thinking of selling paying foreign dividends that are taxed at a 15-20% higher tax rate than Canadian dividends? Canadian dividends benefit from the dividend tax credit, resulting in lower taxation than U.S. or other international dividends. On a 3% annual dividend, you may save 0.6% annually just on tax on the annual income, which helps offset the capital gains tax hit.
If the investment with the deferred capital gain is a mutual fund, saving 1-2% could be easy if the mutual fund has a high management expense ratio (MER) of 2-3%. Diversifying into investments with lower fees, whether on your own or with an investment adviser, could save the 1-2% you need to come out ahead over the next 10-20 years.
Related article: Management expense ratios do matter
The other, less tangible benefit of selling a winner that has become too large a portion of your portfolio is diversification. If you have a single bank stock that makes up half your investments, I’d say there are worse stocks to be overweight, but you are still losing some of the benefits of diversification in your portfolio. Diversification return – the incremental return a portfolio earns due to being diversified – is difficult to quantify. But no doubt it could account for some of the additional return required after selling a winner and paying a big capital gains tax bill to make it worth it.
Another interesting option comes from a company called Purpose Investments. As far as I know, their solution is a one-of-a-kind in the Canadian market. They have an In-Kind Exchange Fund that enables an investor to “diversify your single stock risk without a current taxable disposition.” Purpose allows you to transfer shares of North American companies into one of 13 different Purpose exchange-traded funds (ETFs) on a tax-deferred basis. The new ETF units that issued to you have the same tax attributes as the stock transferred – the same cost for tax purposes and the same market value. From that point forward, the ETF units will fluctuate and your capital gain may grow or shrink accordingly. But at least you’re diversified as a result.
You may or may not be inclined to buy ETFs or even Purpose’s ETFs if it weren’t for the capital gains tax hit. But it could be a solution for the right investor.
Horizons is another ETF company offering a similar in-kind transfer process, but it only applies to “specific individual fixed income securities or select fixed income ETFs.” It’s unlikely your fixed income investments have big capital gains associated, but this is an option for capital gains deferral.
If anyone else knows of similar options, I’d love to hear about them.
If you make charitable donations of any significance, donating shares with deferred capital gains instead of using cash could be a way to be philanthropic and also divest of your high-capital gain shares. You’ll get credit for the donation based on the fair market value of the shares donated, but you’ll also avoid the capital gains tax. Most charities accept shares instead of cash, but you’d have to be donating shares with a value of more than just a few hundred dollars (into the thousands) for the paperwork involved to be worth it (versus just making a cash donation).
I came across a situation recently where a client had a large, deferred capital gain on a rental property he was selling. After discussion with a tax lawyer, the client decided to transfer the property to a corporation before the sale.
The transfer to the corporation was allowed on a tax-deferred basis, at the original cost, called a section 85 election.
The capital gain took place in the corporation, with capital gains tax payable at 25%, versus the taxpayer’s 27% personal tax rate. This 2% differential wasn’t the motivating factor. Instead, it was something called Refundable Dividend Tax on Hand (RDTOH). RDTOH is a notional account that tracks a corporation’s tax paid on certain types of investment income, including taxable capital gains (one-half of a total capital gain).
As you pay out dividends from a corporation to a shareholder, the corporation claims a refund of $1 for every $3 of dividends paid out.
If shareholders of the corporation can draw out dividends at a tax rate lower than 33%, the 33% tax refunds of RDTOH that the corporation receives can make the exercise worth it.
This could be the case if someone is preparing to retire and expects to have a lower income before long or if someone has other family members they support financially who can be shareholders.
In this particular case, there were other motivating factors that go beyond the scope of this article (OAS clawback, estate freeze, family dynamics, etc.). There were also legal and accounting fees, plus land transfer tax costs to take into account to ensure the transaction was worth it.
Suffice it to say that you would need to have a considerable capital gain (hundreds of thousands or millions) and shareholders of the corporation in a low tax bracket for several years to come. Ideally, you would be in a jurisdiction with low land transfer tax (like Alberta, Saskatchewan or Newfoundland).
Besides extraordinary cases like this, I think real estate investors need to consider their return prospects moving forward. Rents in some cities are fairly low as a percentage of rental property market values – so-called capitalization or cap rates – so it could be worthwhile considering how strong the reliance is on capital gains to continue to earn a decent real estate return.
Real estate prices in certain cities, notably Vancouver and Toronto, have also been appreciating much more than the long-term trend. Prices may still be lower than those in many other international cities, but Vancouver and Toronto real estate is overvalued based on almost every possible long-term or relative measure. And lots of smart people are expressing concerns. At least considering taking profits, despite the capital gains tax hit, could be prudent.
If someone has an unincorporated business and they sell it, the income is taxable and they can have a big personal tax hit. Successful, saleable businesses are usually structured as corporations, but not always.
Regardless, it may be possible to transfer a sole proprietorship or partnership into a corporation on a tax-deferred basis to take advantage of the lifetime capital gains exemption.
The 2017 capital gains exemption is $835,716 for QSBC shares and $1,000,000 for a qualified farm or fishing property. There are certain adjustments that may reduce this lifetime maximum (cumulative net investment loss balance, previous capital gains deduction claims), but many taxpayers will have access to the full exemption.
The rules for ensuring a QSBC share sale or farm or fishing property sale qualify are complex. You should get professional tax advice well in advance of a potential sale to ensure that you are eligible.
If your capital gain may be millions of dollars, having other family members as shareholders – either directly or through a family trust – may allow you to use multiple capital gains exemptions to shield the sale proceeds from taxation.
All that said, I can tell you that I’ve built out retirement plan scenarios for business owners to look at selling their business, incurring the tax consequences and reinvesting the proceeds versus hiring a manager to continue to run their business. Sometimes, there can be a compelling financial reason not to sell. Often it’s because the business is more profitable and provides a higher return on investment than they will ever be able to generate in stocks and bonds, but sometimes, the tax is a deterrent.
However, what’s better financially isn’t always what’s better from a lifestyle perspective. For a busy business owner who is entrenched in their business, hiring a manager may mean they never fully retire.
Tax deferral shouldn’t be the only reason you hold an investment, whether it’s stocks, mutual funds, real estate or a business. You do have options. And you can’t defer tax forever. Capital gains are triggered on your death (or the second death if you have an eligible spouse). So someday, your capital gains tax will be paid regardless. It may be “worth it” on many levels to sell sooner rather than later.
If nothing else, consider realizing some of your capital gains over multiple years, at a time when your income is low, or saving RRSP deductions to claim in the year of sale if you will be in a higher tax bracket in that year.