Businessman Walk Over Cliff Gap Risk Mountain Balancing Flat Illustration

With year-end approaching and record highs in many equity markets, your clients could be sitting on substantial accrued capital gains in their non-registered portfolios. November is the perfect time to have the rebalancing discussion — especially if you fear an increase in the capital gains inclusion rate.

Timely rebalancing

For starters, let’s say the client’s goal was to have a balanced portfolio of 70% equities and 30% bonds or fixed income. With equity markets soaring in recent months and bond markets down, you may find that your client’s portfolio is now sitting at 80% equities and 20% fixed income. If their long-term plan is to maintain a 70/30 mix, you might suggest that the client consider rebalancing the portfolio by selling some equities and buying more fixed income.

But that’s where some investors get stuck, as they’re reluctant to sell an investment that has performed well because they don’t want to pay the tax, a phenomenon known as the capital gains lock-in effect. But if you can explain to the client that eventually they (or their estate) will have to pay the tax, it often comes down to timing — pay the tax now or later.

Of course, that’s not necessarily the full story if you believe your tax rate may be higher or lower in the future. This could happen due to personal circumstances or because the government decides to raise or lower (LOL!) the tax rate itself.

If the client’s tax rate will be substantially different in 2022, perhaps because they may have just started or returned to work in 2021 and thus have a lower income this year, they may wish to rebalance their portfolio in 2021 rather than wait. Conversely, if they believe their tax rate will be lower next year, they might consider realizing those gains after Dec. 31.

Some investors, however, fear that the capital gains tax rate itself could be hiked, possibly even before the end of this year. While an increase wasn’t in the Liberal election platform, some worry that, given the minority government, the NDP, which had in its playbook to hike the capital gains inclusion rate to 75%, may hold some sway over the Liberals in setting tax policy in the upcoming Parliament, which is set to resume on Nov 22. An economic update could follow shortly thereafter and, while traditionally such statements don’t contain tax measures, it’s possible that tax changes could be introduced well before a spring 2022 budget.

Indeed, the last time the capital gains inclusion rate was changed, it was done as part of former finance minister Paul Martin’s economic statement presented in the House on Oct. 18, 2000. At that time, the capital gains inclusion rate was lowered to 50% (from 66 2/3%), where it remains. The change was effective immediately, as of that date.

Clients who fear an imminent increase in the inclusion rate may wish to consider rebalancing a portfolio by taking gains currently, thereby locking in a 50% inclusion rate. There are also more sophisticated tax strategies that could buy them some time if they’re unsure what could happen to the inclusion rate, including rolling appreciated securities to a holding company on a tax-deferred basis and then electing to recognize (or not recognize) the gain afterwards, depending on what happens to the rate in the months ahead.

Tax gain donating

Finally, an alternative to selling and realizing a capital gain in 2021 would be to consider gifting publicly traded securities, including mutual funds and segregated funds, with accrued capital gains “in-kind” to a registered charity or a foundation, including a donor-advised fund. This not only entitles the client to a tax receipt for the fair market value of the security being donated, it eliminates the capital gains tax too.

Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.