Investors can have good reasons to sell profitable, taxable investments, but the decision should always align with their broader goals.GETTY IMAGES
There comes a time when investors need to sell a security, whether it’s for portfolio rebalancing, buying a property, or funding their retirement.
Regardless of the reason, investors should be aware of the potential tax implications of pulling their money from the markets.
“When you do have a gain, that’s a great thing, but that could lead to a tax liability,” says John Waters, vice-president of tax consulting services at RBC Wealth Management in Toronto.
A capital gain is an increase in the value of an asset, such as a stock, over the purchase price. A realized gain is when the profit is locked in after the asset is sold. In Canada, 50 per cent of realized capital gains are included in taxable income, or what’s known as the capital gains inclusion rate.
In some cases, the gains can be significant, says David Wright, senior wealth advisor at Wright Wealth Management of BMO Nesbitt Burns in North Vancouver. “There have been, over the last couple of years, some names certainly within certain sectors that have done really well.”
Unrealized gains, sometimes known as paper profits, are increases in value while you still hold the investment.
If the money is in a registered account, such as a registered retirement savings plan (RRSP), selling assets with capital gains will not result in any tax owing. However, withdrawals from an RRSP with realized capital gains are taxable as income. An exception is a tax-free savings account (TFSA) where, as the name suggests, gains and withdrawals are tax-free.
Using losses to manage gains
Investors can reduce taxes owed by pairing realized capital gains with realized capital losses from the current year or past years – a strategy known as tax-loss harvesting, says Evelyn Jacks, a Winnipeg-based tax expert and president of the Knowledge Bureau.
“That’s why it’s important to keep good records of your investment transactions, especially for non-registered accounts for realized losses,” says Ms. Jacks, an author of several tax-related books.
Realized past losses can be carried forward indefinitely and used to offset taxable gains, even for a final return upon death. The calculation can be nuanced, which is why Ms. Jacks recommends working with a tax professional to determine the correct taxes owing and ensure the cash is readily available to pay the Canada Revenue Agency (CRA) upon filing the tax return.
Another implication of a sizable capital gains tax bill is that the CRA may require quarterly tax instalments in the following tax year. It happens when gains exceed $3,000 in a calendar year. That said, if you anticipate your income will return to normal levels the following year, Ms. Jacks says taxpayers can probably ignore the installment payment notice from CRA.
If you suspect you may have more realized gains the next year and beyond that will exceed $3,000 in taxes owing annually, the conservative strategy would be to pay the suggested installments, Mr. Waters adds.
Adjusted cost base considerations
Another tax nuance comes with the sale of mutual funds and exchange-traded funds (ETFs).
A portion of fund distributions often involves a return of capital, which represents a return of the investor’s original invested capital in the fund. It’s not immediately taxable but instead will reduce the adjusted cost base (ACB) for tax purposes of the units held by the investor in the fund. (ACB is the total investment cost – purchase price plus fees to acquire the investment and reinvested distributions – used to calculate taxable capital gains or losses upon selling.)
A return of capital can increase the capital gain when selling units beyond the difference between the fund units’ original purchase price and the selling price, Mr. Waters says, which can bump up the capital gains taxes owing.
Distributions that are reinvested to purchase more fund units, or dividend reinvestment plans (DRIPs) to acquire additional shares, can have the opposite effect, increasing the ACB and potentially reducing the size of a realized capital gain and taxes owing down the line, Ms. Jacks says.
Calculating the adjusted cost base can be complicated, she says, adding brokerages often can help investors with this calculation. But others may require assistance from their advisor or even a tax specialist, Ms. Jacks adds.
Using donations to give back and reduce taxes
Another common strategy to mute the impact of taxable capital gains and eliminate the need to calculate the ACB is to donate all or part of profitable securities in-kind to charities, Mr. Waters says.
“It’s far better to do that with an appreciated security than selling that investment, triggering the gain, paying tax … and then donating the proceeds,” he says.
With in-kind donations, capital gains taxes aren’t applicable, and the security’s market value can provide a substantial charitable tax credit, he adds.
Switching advisors can also trigger taxes
Investors can also be taxed when switching advisors or brokerages, says Darren Coleman, portfolio manager with Coleman Wealth at Raymond James in Oakville, Ont.
Mr. Coleman says this generally arises when investors own proprietary investment funds affiliated with the advisor they had been working with. “Then, you likely have to sell because the new advisor doesn’t have access to those products,” he says.
However, transfers between firms in registered accounts can be done without triggering a tax event.
Investors can have good reasons to sell profitable, taxable investments, but the decision should always align with their broader goals, Mr. Wright says. “You want your financial plan to dictate decisions rather than market-driven anxiety.”