John Campbell, CA, CFP, partner, tax group leader, Hilborn, Toronto
Claudio Piron, CA, CFP, FCSI, CSWP, senior investment advisor, Dundee Wealth, Mississauga, Ont.
Josh is a 35-year-old single software designer living in London, Ont. Ever since he got his first paycheque from a part-time job, he’s been investing in RRSPs.
With at least three decades to go before retirement, Josh’s portfolio is invested in global mutual funds, commodity stocks and specialty funds. Through diligent saving, he has managed to put away $110,000.
His $70,000 annual salary covers his mortgage and all living expenses. In addition, he inherited his grandmother’s house four years ago, which he’s been renting out at a rate that covers property taxes, utilities and upkeep.
His grandparents bought the property in the 1950s for $15,000, and it’s now worth $300,000 because of the size of the lot and its proximity to the University of Western Ontario.
The city now wants to expropriate the property for a parking lot, so he’ll face a significant capital gain. His RRSP investments have dropped, and he has a significant capital loss on paper. Josh wants to offset the capital gain with his RRSP capital losses.
3 out of 10. Josh didn’t understand all the details of RRSPs when he started investing. The advisor will have to point out some of the drawbacks, and work with the client to develop a more balanced investment strategy while finding a way to minimize the expected capital gain.
Josh’s grandparents raised him after his parents were killed in an accident. His grandmother was a bookkeeper and instilled in him the importance of saving and investing. After his grandfather died, Josh’s grandmother moved in with him, but she kept her home and rented it out.
Josh started investing in RRSPs at age 16 after speaking with his grandmother’s investment representative at her bank. He showed a high risk tolerance so the rep suggested he invest in high-yield, high-risk stocks.
The stocks fared well during the tech boom, but have since fallen consistently throughout the last decade. So far this year, he’s lost approximately $35,000 on paper.
Josh has about $25,000 in a savings account, and contributes to a defined-contribution pension plan at work, but has no non-registered investments.
He is facing a significant capital gain when the city expropriates the house he inherited. The estate paid the initial capital gains when he inherited four years ago, but the house has since increased $50,000 in value. He wants to know how to minimize the tax hit and is looking for advice on revamping his investments going forward.
He’s sought out a new advisor, who administered a new risk-tolerance questionnaire. The latest analysis indicates he should be in 30% fixed-income and 70% equities.
John Campbell, tax group leader with Hilborn in Toronto, says financial institutions have done a good job selling the positive benefits, such as the immediate tax savings, of an RRSP contribution, but don’t always explain the downside.
Funds can be transferred in and out of different investments within an RRSP without incurring a taxable event, but those same gains or losses can’t be used to offset gains or losses outside the plan.
Transfers out of the RRSP must be made to another RRSP or RRIF or it will trigger tax.
So, Josh can’t use the capital loss in the RRSP to offset the capital gain the expropriation will generate, but he can rebalance his investment portfolio going forward to prevent similar incidents from occurring in the future. Within the registered portfolio, he can sell the stocks and purchase interest-bearing investments without triggering tax.
“Sometimes knowing the bad news is worthwhile because it lets clients reconfigure their portfolios,” concludes Campbell.
Not all investments are optimal for an RRSP.
Investments that generate interest income and foreign income (those with the highest tax consequence) should be held within an RRSP. Riskier investments that have higher potential for capital losses should be held in a non-registered account to maximize potential tax efficiencies.
Here’s what should go where.
Claudio Piron, senior investment advisor with Dundee Wealth in Mississauga, Ont., says, “What happens to investments inside an RRSP is meaningless from a tax standpoint because they do not receive preferential tax treatment.
“While he can’t use the capital loss in the RRSP to offset the capital gain from the real estate transaction, he might be able to negotiate with the city to defer the capital gain hit by paying him the proceeds over four years, rather than in a lump sum.”
He adds, “He could then take a reserve against the capital gain, recognizing only the prorated portion received. The entire gain would have to be realized within the four-year timeframe. It isn’t going to change the tax hit, but it would spread the impact.”
To avoid large future gains or losses, Josh needs to revamp his investment portfolio (see “Investments to hold in an RRSP,” right).
Piron adds Josh could sell the underperforming stocks in his RRSP and buy them back in a non-registered account. He could do an in-kind transfer of stocks to a non-registered account, and then transfer the dollar-value equivalent to the registered account and buy interest-bearing investments.
This can normally be accomplished without trading fees if the registered and non-registered accounts are at the same financial institution.
Any additional capital losses would be accrued in a non-registered account, which would then offset the capital gains of the expropriation and future capital gains would be taxed as capital gains rather than income.
Josh was disappointed he couldn’t offset the capital gain with his significant capital loss in the RRSP. He made immediate changes to his portfolio to incorporate a non-registered component. He is waiting for a decision from the city about the expropriation and decided to leave his RRSP investment direction as is, hoping to recoup the investment in time.
Lisa MacColl is an Ontario-based financial writer.