Portfolio reviews: capital gains considerations

Investment insight

Here are four things that you should think about when rebalancing non-registered portfolios and potentially triggering a capital gain.

Look for other non-registered investments where you can realize a capital loss to offset the capital gains.

If you don’t have any capital losses to use but your spouse does, there’s the potential to transfer the capital losses to yourself, as this article explains: "Capitalizing on Capital Losses".

It’s also important to note that any capital losses must be first used against capital gains realized in the same calendar year. However, any excess capital losses can be used to reduce capital gains in any of the three previous years or in any future year.

Be strategic about realizing capital gains.

You may not have to realize all the capital gains in one specific year. For example, if you were to spread the capital gains over multiple years, it may allow you to stay in a lower tax bracket. Even just waiting until after calendar year end allows you to defer paying tax on capital gains for one year.

An opportunity could also present itself to be selective as to which investments you rebalance out of depending on the gain or loss position of the investment held in the account. Investments in a loss position or with a small gain may be most desirable to rebalance first.

When rebalancing your portfolio and realizing capital gains, you’re not paying extra tax but are simply pre-paying taxes.

A capital gain will eventually be realized, whether due to either a switch to another fund, a redemption, or death. You should look at potential capital gains from the perspective of what’s the opportunity cost of realizing the gain and paying the tax early to choose a more suitable investment versus continuing to hold the same investment and deferring the capital gains tax.

Example

Take an investor with a non-registered investment worth $1 million and an adjusted cost base (ACB) of $900,000, which amounts to a $100,000 unrealized capital gain. Let’s also assume the investor is at the top marginal tax rate of 50% (estimate used for illustration purposes). If the investor sells the investment and realizes the $100K capital gain, the investor will pay tax of $25,000.

Remember, the investor is going to realize that capital gain at some point and pay the tax of $25,000 (assuming all things remain the same). So, the question is, how much could be earned, after-tax, on the $25,000? That’s the opportunity cost of realizing the capital gain early by rebalancing now.

If we assume, the investor will realize the capital gain in 10 years and earn an annual pre-tax return of 5% (assuming all growth is tax deferred for the 10 years), the investor will earn approximately $11,800 after tax. On a million-dollar investment, that’s a total net return of 1.18% over the 10 years.

If the new investment can earn an extra, total, after-tax return of at least $11,800 over those 10 years, the investor will be just as well off or better. Put another way, if the investor can take the after-tax amount of $975,000 ($1 million less the $25,000 in tax) and earn an extra, total, after-tax return of 1.21% ($11,800 / $975,000) over those 10 years, it’ll justify realizing the capital gain now.

This article talks about realizing capital gains from the perspective of avoiding probate and estate administration fees, and other segregated fund benefits, but the principle is the same: "Taking capital gains or losses now to avoid probate and estate fees later".

Part of the capital gains realized by a corporation may be paid out to shareholders tax free.

Capital gains realized by a corporation are also taxable with a 50% inclusion rate. However, the other 50% that’s not taxable increases the notional capital dividend account (CDA). Any balance in the CDA can be paid out to a shareholder tax free by way of a capital dividend. This can be very attractive to shareholders, as they’re often looking for ways to get money out of their corporation on a tax-free basis.

For more information on the CDA and how capital gains, and other investment, income is taxed within a corporation, see this article: ”Taxation of investment income within a corporation.”

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03/2024

Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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