Doug and Jeff are typical examples of clients who have been burned by investments in the past. They want to play it safe now. However, they must look to the future. The good news: At least in the short term, they will likely be able to deduct some of their investment losses for tax relief.
Please note that before any loss can even be reported for tax purposes, the loan or guarantee must be considered a bad debt. Since the restaurant went out of business and has no plans to reopen, Doug and Jeff’s investment meets this criteria.
I assume that Doug and Jeff used unregistered funds to invest in the restaurant, given that their TFSA is $32,000 per person (maximum) and it is unlikely that they would choose to withdraw money from their RRSP. If the couple redeemed any mutual funds or stocks to finance their restaurant investment, they would generate some capital gains during that time, which they may be able to write off against capital losses on their restaurant investment.
The key thing: how the restaurant investment was created. If Doug and Jeff were involved in a partnership with the restaurant owner, they could be personally liable for any debts the business owes to creditors. On the other hand, any losses they suffer will be considered an ‘allowable investment loss’ and will be able to be deducted from their employment income for tax purposes. They don’t have to claim all of their losses right away, but they can only go back three years, so they should probably cash in any capital losses as soon as possible.
We also need to determine how much of these losses are attributable to Doug and how much to Jeff, and how the write-offs will affect each of them’s marginal tax rate. The goal should be to get the maximum tax refund possible. For example, there may be a scenario where the first $20,000 will save Jeff 43%, but the next $5,000 will only save him 35%. In this case, you may want to keep your last $5,000 and consider using it next year.
Disclaimer: It will be a year later and Jeff can only roll back the loss for three years (though he can carry it forward indefinitely). He will have to ask himself whether there will be enough capital gain to offset the loss if he waits. However, it’s important to remember that Doug and Jeff don’t actually have to sell stocks or mutual funds to realize capital gains. Switching from one mutual fund to another would be enough.
So in the end, their $175,000 loss isn’t actually $175,000 when you consider the after-tax impact. The emotional and financial blow of loss should not be underestimated. This took away almost two years of savings (less the tax relief they would receive on the loss). Still, Jeff and Doug need to understand that given their time horizon, they have a lot of potential to grow their investments.
If they insist on only holding fixed-income products like bonds and GICs, they need to understand that they are fully taxable in the year earned unless they are held in registered accounts. Instead, I would encourage them to invest in equity funds in unregistered accounts; partly because they offer greater growth opportunities, but also because dividends and capital gains are more tax-advantaged. In fact, Doug and Jeff would need to realize some capital gains if they were to write off capital losses on their restaurant venture.
If Doug and Jeff are adamant that safety is their primary motivation, I would also talk to them about ring-fenced funds that offer a guarantee of capital while also providing an opportunity for growth. The couple must understand that there are costs associated with this security in the form of a higher management expense ratio, but it would at least be a better option than a GIC. Once they see some growth in their seg fund, they may want to look at other options, such as an investment fund that holds blue-chip stocks.
In conclusion, Doug and Jeff need to talk to their financial advisor to fully understand the impact of investment losses on their financial situation. Once they recover from this bad investment, they will be able to look forward to the future in the most effective way possible.
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