Share with your spouse and erase a cash drain

Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.

tcestnick@waterstreet.ca

My kids are growing up - fast. In just two years, I'll be the father of a teenager. It seems that raising teenagers is not for the faint of heart. In my case, my parents just sealed me in a wooden barrel for six years and left an opening in the top just big enough for food and other essentials, such as hair gel.

My father told me the other day that there's really nothing to be afraid of in raising teenagers, as long as I have my wits about me, and a long list of useful tools: night vision binoculars, jumper cables, a medical emergency kit, the phone number for 911 and a good cellphone plan.

It seems that tax planning is much the same as raising teenagers: You try to keep the cash drain to a minimum. Many tools are available to make your life less taxing. No, I'm not talking about night vision binoculars, but there's one "tool" that's worth dusting off annually as we approach the end of the year. I'm talking about transferring capital losses to your spouse.

THE STRATEGY

This idea may work when you have capital losses on paper. Normally, for example, you could sell off investments that have dropped in value and use the capital losses to offset capital gains realized this year, or in one of the three prior years (2008, 2007 or 2006). But what if you don't have capital gains against which to apply those losses?

Check your spouse's portfolio. If he or she has capital gains this year, or gains reported in one of the three previous years, it may be possible to transfer your unrealized capital losses to your spouse for him or her to use. This could save tax immediately, and potentially recover tax dollars paid in a previous year.

THE MECHANICS

How does this work? There are three basic steps to take. So, follow me here.

Step 1: Sell your securities on the open market. Suppose, for example, that you purchased shares in XYZ Corp. for $100,000, but today those shares are worth $40,000. You have a $60,000 capital loss on paper (an unrealized capital loss). Suppose also that you don't have capital gains to apply those losses against. But let's assume your spouse reported $60,000 in capital gains two years ago. So, you'd like to transfer your unrealized capital losses to your spouse. The first step is for you to sell those XYZ shares on the open market.

Step 2: Your spouse will now purchase the same class of XYZ shares on the open market, within 30 days of your sale. In our example, your spouse will purchase the same number of shares that you sold (let's assume the share price is still the same as Step 1, so your spouse purchases $40,000 worth of XYZ shares).

Two things happen here: First, the capital loss that you realized when you sold your XYZ shares in Step 1 is denied under the superficial loss rules in our income tax act. Those rules say that when you sell a security at a loss, and you (or someone affiliated with you - including your spouse) acquire the same security in the 30-day period after, or before, your sale (a 61-day window), the capital loss will be denied.

Second, your spouse has purchased the shares for $40,000, so his or her adjusted cost base (ACB) is $40,000 - or so you'd figure. But not quite. That $60,000 capital loss that was denied to you doesn't disappear forever. Our tax law causes that denied capital loss to be added to the ACB of the newly acquired shares. So, your spouse's ACB is actually $100,000 ($40,000 plus $60,000). Our tax law allows this so that you eventually can gain the benefit of that denied capital loss, when the XYZ shares are ultimately sold for good.

Step 3: Now, your spouse can sell those XYZ shares for their current value of $40,000. Since the ACB is $100,000, he or she will report a $60,000 capital loss on a tax return. This capital loss can offset his or her capital gains. It's important that your spouse wait until that 61-day window is over before selling. And if your spouse is going to carry the loss back to a prior year, a Form T1A will have to be filed with his or her tax return next spring.

To transfer a loss in 2009, be sure to implement Step 1 of this strategy on or before Nov. 21, 2009.