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Making the most of capital losses

You've got to wonder about your ability as a manager of people when those who report to you send you an e-mail with the subject: "Prison is better than work."

Just such an e-mail appeared in my inbox this week, sharing the following insights.

1. In prison, you spend the majority of your time in an 8-by-10 cell. At work, you spend the majority of your time in a 6-by-8 cubicle.

2. In prison, you get time off for good behaviour. At work, you get more work for good behaviour.

3. In prison, you get three free meals a day. At work, you only get a break for one meal, and you pay for it yourself.

4. In prison, you can watch TV and play games. At work, you get fired for watching TV and playing games.

5. In prison, you get your own toilet. At work, you have to share with a guy who drips on the seat.

Talk about seeing the silver lining in the prison cloud. How are you at looking on the bright side these days as an investor?

As investors, the dark cloud of the market has been hanging over us for some time. Can you see the silver lining? Is there some way we can make lemonade out of the lemons the market has handed us this year? You bet. Just deal with your capital losses properly.
The carryback

It's no secret that any capital losses you've realized can be offset against any capital gains in order to save you tax. If you've triggered capital losses in 2002, those losses must first be applied against any capital gains you have this year (yeah, as if), and can then be carried back up to three years, or carried forward indefinitely, to the extent that you can't use them this year.

Here's the critical point: These past few months of 2002 represent your last chance to trigger a loss that can be carried back to 1999. Capital gains in 1999 were taxed at higher rates than capital gains today, so you'll generally save more tax by triggering capital losses this year and carrying them back to 1999 than you will by using those losses in other years.

You may recall that, prior to Feb. 28, 2000, three-quarters of a capital gain was subject to tax, whereas just one-half of any gain is taxable today. In fact, any capital gains realized after Oct. 17, 2000, are subject to that 50-per-cent inclusion rate.

What difference can this make? Suppose you live in British Columbia and have a $40,000 realized capital loss this year. If you apply that loss against capital gains realized this year, you'll save $8,740 in taxes, if you're in the highest tax bracket. On the other hand, if you're able to carry that loss back to 1999, you'll save $15,687 in taxes as a result of that same capital loss. That's an additional $6,947 you would save by carrying your loss back to 1999, if possible. Regardless of your province of residence, you'll generally find yourself better off applying your losses to 1999 where you can.
The estate plan

Why not take advantage of your capital losses and do some effective estate planning at the same time? Consider giving your children some of your investments that have dropped in value. Doing this will accomplish three key things:

1. You'll trigger losses you can use. When you give those investments to your children, you'll be deemed to have sold them at fair market value. Since they've dropped in value, this will trigger a capital loss that you can use. The loss won't be denied under the superficial loss rules because your kids aren't "affiliated" with you under Canadian tax law.

2. You'll accomplish an estate freeze. An estate freeze involves passing the future growth of an asset to someone else -- often the kids -- so that they will be taxed on that growth, not you.

The drawbacks of this method of freezing an estate is that you'll no longer have control over those assets, and you won't be entitled to an income from them, either. Nevertheless, you'll avoid tax during your lifetime and at the time of death on any future growth of the investments. If you're concerned about the control issue, talk to a tax pro about other methods of freezing an estate.

3. You'll minimize probate fees. If you live in a province where probate fees are levied, you'll avoid those fees on any assets you give away during your lifetime.

The name of the game? Making lemonade out of lemons before the end of this year.
Tim Cestnick, CA, CFP, TEP is author of Winning the Tax Game 2002 and Winning the Estate Planning Game. He is managing director, Tax Smart Services, at AIC Ltd.

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