Making lemonade: Strategies for when the markets are giving you lemons
Look, we probably don’t have to tell you it’s been a hard year to be an investor. Lingering effects of the pandemic, rising inflation, supply chain constraints, war and other external factors have produced significant declines in the markets that could make even the safest of investors sweat.
While it may seem like the only thing you can do in a down market is to hold tight, there are actually a few unique tax planning opportunities that could position you to get ahead. Let’s take a look at some of the ways you can use a market downturn to your advantage:
Tax loss selling
Tax loss selling is a common strategy for reducing taxes on capital gains, which involves selling off investments—including stocks, real estate and others—that have declined in value in order to generate capital losses. While it may hurt to see capital losses realized, those losses can be used to offset any capital gains generated during the year, thereby reducing taxes payable for the year.
Additionally, net capital losses realized in a year can be carried back to the three prior tax years (i.e., 2021, 2020 and 2019) to offset any capital gains generated in those years and reduce income taxes already paid (which may result in a refund). Alternatively, these losses can be carried forward indefinitely and applied against future capital gains, allowing for more flexibility in when you wish to reduce your taxes.
It’s important to note that capital losses may be denied on the disposition of an investment if they fall under the superficial loss rules, which are as follows:
- The same or identical property was acquired by you or a spouse during the period beginning 30 days before the disposition and ending 30 days after the disposition; and
- At the end of the period, you or a spouse owns, or had the right to acquire, the same or identical investment.
Note: This includes your RRSP, TFSA, RRIF and properties held in you or your spouse’s company.
Estate (re)freeze for investment corporations
As we outlined in our article on succession planning for a successful retirement, an estate freeze is a strategy where the accrued value of an individual’s shares in a corporation are exchanged for “frozen” fixed value preferred shares. This strategy allows for future growth of the company to attribute to “growth” common shares held by family members.
For corporations that have previously implemented an estate freeze, a downturn in the markets may be a good time to review the overall value of your corporate assets. If the value of a corporation’s assets has significantly decreased, a re-freeze could yield many benefits.
In a re-freeze, the preferred shares you own with a higher redemption value are exchanged for new preferred shares with a value equal to the current reduced value of the company. If the preferred shares are worth less than their face or redemption value, the common shares’ value is nominal.
This can provide several advantages, including:
- Allowing future growth to go to your common share holders (family members or discretionary family trust);
- Reducing the value of your estate and associated taxes owing on death;
- Allowing for dividends to be paid to common shareholders, as corporate bylaws would have otherwise prevented any dividends to be paid when the value of the company is below the value of the preferred shares; and,
- Extending the tax-life of a family trust by introducing a new family trust to hold growth shares of the company (the old family trust shares can be repurchased nominally).
Determining the fair market value of the company’s shares is a critical part to executing this plan. Your DMCL advisor can help with this process and examine how an estate freeze or re-freeze could work to your benefit.
Individual Pension Plan (IPP) revaluations
As a refresher: an IPP is an employer-sponsored pension plan that can be setup by and for a single person, in which contributions accumulate and compound while being fully tax sheltered. Contributions made to an IPP are tax deductible for your business in the fiscal year contributions are made (or 120 days after the fiscal yearend).
Generally, an actuary—the person responsible for determining your plan has sufficient assets at the time of retirement—will provide a valuation report on the same yearend date as your business. This report will assess the IPP financial position to determine the IPP contributions for subsequent years. However, some business owners choose to pursue a revaluation of their IPP with a selected valuation date of when the value of their assets are in a deficit position.
During a market downtown, this revaluation allows for an additional contribution amount equal to the deficit described above, and may also allow for a new annual IPP contribution amount higher than before. The higher contribution amounts will benefit your business if you want to reduce the tax liabilities in a given fiscal year, while also increasing the assets that will be available to you at retirement.
A downturn in the markets can be rattling for any investor, but having the right strategies in place can make all the difference. Talk to one of DMCL’s tax experts about how you can use this situation to your advantage and they’ll be happy to identify the right tax planning opportunities for your unique financial situation.
Article written by Nav Pannu, CPA