Tax slip surprise

The value of my investment is lower – so why do I have a tax bill?

It’s something that puzzles investors every tax season: they have an investment in a mutual fund or segregated fund contract that declined in value between January 1 and December 31, and yet they’ve received a tax slip listing taxable interest, dividends or capital gains.

There’s a straightforward reason for the tax slip: the fund has either received income (interest or dividends) from its underlying investments during the year or sold underlying investments at a capital gain. Even though the price of the fund has dropped, the taxes due on transactions within the fund have to be passed along to investors.

Let’s look at some examples to see how this works.

Example 1: The fund earns income

Imagine you own a small apartment building. The current value of the building may be less than when you purchased it, but you will still have to declare any rent you collect as income. In a fund, the principle is much the same. Any interest or dividend income earned by the fund’s underlying investments must be taxed in the hands of investors – so investors receive a tax slip even though the fund’s price has declined.

Example 2: The fund realizes capital gains

When you sell an investment that has increased in value, you may realize a capital gain. The capital gain is calculated as the difference between your selling price and your adjusted cost base (ACB). The ACB isn’t always the purchase price. Rather, it’s the amount of the investment that has already been taxed. A number of factors can affect your ACB.

Similarly, when a fund manager sells an investment that has increased in value, the fund realizes a capital gain – also calculated as the difference between the selling price and the adjusted cost base. And, the gain is flowed through to the fund’s investors. As a result, you may receive a tax slip for capital gains even if some of the capital gain occurred before you bought your units and even if the value of your fund units has dropped.

For simplicity, let’s assume a fund holds only one stock and you are the only investor. You paid $100 for your investment on January 1. On December 31, the value of the investment is $80. However, the fund manager bought the one stock 10 years ago for $10. If the manager sold the stock on June 30 when the stock was valued at $85, the fund would realize a capital gain of $75. As the only investor, you would have to report this $75 capital gain on your tax return – even though the value of your investment has dropped.

That said, investors never pay tax on more than they actually make in profit. After you pay tax on the $75 capital gain, your ACB increases by $75 – in this example, to $175. If you sell the investment while the price is still $80, you will realize a capital loss of $95. If you wait and sell the investment when the price is $150, you will still realize a capital loss of $25 even though the value of your investment rose to $150 from your purchase price of $100.

Discuss tax minimization strategies with your advisor

There are a number of approaches you can take to reduce the impact of reported capital gains on your taxes. For example, if the value of your fund units is lower than your ACB, you could sell to realize a capital loss and then reinvest the money in a different fund. In the example above, you could sell at $80 and realize a capital loss of $95, which more than offsets the $75 capital gain generated by activity within the fund. If you have no other capital gains reported, you can use the remaining $20 capital loss to offset capital gains in the three previous years, or in any future year. Your advisor can recommend the best strategy for your situation.

AT A GLANCE

January 1, 2008: Fund manager buys stock for $10

January 1, 2018: You buy fund units for $100

June 30, 2018: Fund manager sells stock for $85

December 31, 2018: Your fund units are worth $80

RESULT:

The value of your investment has dropped from $100 to $80, but you receive a tax slip for $75 in capital gains and your ACB increases to $175.

WHEN DOES YOUR ADJUSTED COST BASE CHANGE?

Here are three common reasons your adjusted cost base (ACB) may not be the same as your purchase price:

1. You buy units in the same fund at different times, at different prices

If you pay $100 for 1 unit in a fund and nothing else happens, your ACB is $100 per unit. But if you pay $120 a year later for 1 more unit, your ACB per unit will be adjusted. It becomes the average cost, calculated as the total cost divided by the total units: ($100 + $120) / 2 = $110 per unit.

2. You receive a year-end distribution or allocation

At the end of the year, mutual funds often pay distributions and segregated funds often allocate to investors. The distribution or allocation consists of income and capital gains received within the fun and, as discussed above, the amount is taxable. If you reinvest your distribution from a mutual fund the amount is added to your ACB. If the amount is deemed as an allocation from a segregated fund, this also increases your ACB, however the insurance company tracks your ACB for you. When you sell your investment, this decreases your capital gain or increases your capital loss.

3. You receive return of capital

When an investment pays you “return of capital,” that amount is not taxable because it’s part of your original investment. However, any return of capital is subtracted from your ACB.[1] When you sell your investment, this increases your capital gain or decreases your capital loss. Ultimately, it’s your responsibility to track the ACB for your investments – and it’s critical to do so in order to pay the right amount of tax when you sell. Talk to a tax professional if you have questions about the ACB of any of your investments and to make sure your ACB calculations are accurate.

© 2018 Manulife. The persons and situations depicted are fictional and their resemblance to anyone living or dead is purely coincidental. This media is for information purposes only and is not intended to provide specific financial, tax, legal, accounting or other advice and should not be relied upon in that regard. Many of the issues discussed will vary by province. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. E & O E. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value.

[1] Once the ACB reaches zero, additional payments of return of capital are taxable as capital gains.