There are some things I don't look forward to. Want an example? I'll often be gone on a business trip for a few days, leaving my wife Carolyn at home to deal with the kids herself, which usually leaves her exhausted. I often arrive home very late and find the family sleeping.
And I always know that, the next day, I'm going to hear about how tough her week was, which is not something I look forward to. In the morning, I often wake up grumpy. Other times, I just let her sleep. Oooh. Did I say that?
The only thing more difficult than the morning after a business trip is the morning after I've triggered a significant tax hit by selling an investment for a profit. Today, I want to talk about a strategy that can ease that tax burden.
The problemIf you look hard enough, you might just find a few winners in your portfolio. Looking at cumulative three-year returns, the Toronto Stock Exchange has gained 104 per cent, led mainly by energy stocks (110 per cent), and metals and minerals (104 per cent). The telecom, real estate, and information technology sectors have done well too (gaining 100, 70, and 59 per cent respectively over the last three years).
Can the upside continue? Perhaps, but looking at individual securities in your portfolio might lead you to the conclusion that now is a good time to sell.
The dilemma? You're concerned about a stock dropping in value, and want to sell it right away, but you don't want to trigger a significant tax bill today by making the sale.
A strategy using put options can help. A put option gives you the right, but not the obligation, to sell a security at a specific price (the strike price) within a specific time. This right to sell will cost you a fee (called the option premium). Consider Jason.
Jason purchased shares of ABC Inc. for $20. Today, the stock trades at $35 and he's concerned that the stock price will decline. He wants to protect his profits, but doesn't want to sell and trigger a tax hit sooner than he needs to.
Jason calls his broker and purchases a put option giving him the right to sell ABC shares at $35 until January 2006. He owns 1,000 shares of ABC, and the option premium totals $2,000 ($2 a share).
Jason is now protected from a decline in the value of ABC since, if the value of ABC drops below $35, he's still able to sell at $35 thanks to the put option.
If the ABC stock rises above $35, Jason will still benefit because he's still holding ABC shares. His put option would be "out-of-the-money" in this case, and would expire worthless, but the most he'd lose is the $2,000 premium he paid.
Jason can now hold onto his ABC shares until next January, knowing he's protected from declines in value. If he wants, he can sell his ABC shares next January, deferring his tax liability for a full year until 2006.
Since tax brackets and credits are now indexed to inflation federally and in most provinces, Jason will not only defer his tax bill for a year, but can expect to pay a little less tax next year than he would on his profits this year.
If you like this idea, make sure your put option expires in a future calendar year, and that your option premium will be outweighed by the actual taxes saved and the benefit of deferring the tax hit.
Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.
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