Capital gains may be illusory.

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gaspr
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Capital gains may be illusory.

Post by gaspr »

Hypothetical question. Say I purchased $10000 worth of shares of a company in 1980. This company never paid dividends, only repurchased shares or reinvested profits. Today, I want to sell and my shares are now valued at $30492. This is a capital gain of $20492 of which 50% would be taxable as regular income.

But the entire gain is an illusion. Using the Bank of Canada's inflation calculator, $10000 in 1980 is equivalent to $30492 in 2017 dollars. I am being taxed on inflation. It does not seem fair that CRA gets to raise the tax brackets by the rate of inflation, but we investors can not raise our ACBs by the same rate.

Is this a reason to perhaps harvest gains sooner rather than later? Am I doing the math correctly?
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Re: Capital gains may be illusory.

Post by SoninlawofGus »

gaspr wrote: 28 Apr 2017 13:10
But the entire gain is an illusion. Using the Bank of Canada's inflation calculator, $10000 in 1980 is equivalent to $30492 in 2017 dollars. I am being taxed on inflation. It does not seem fair that CRA gets to raise the tax brackets by the rate of inflation, but we investors can not raise our ACBs by the same rate.
But that's just a bad investment, so bad that I think it defeats the hypothetical argument. In US dollars, $10,000 put into SPY on Jan. 1, 1980 is worth almost $240,000 now.
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Re: Capital gains may be illusory.

Post by DenisD »

I think you are correct. But it's just something we have to live with. If you have money in a HISA earning 1.5%, you're not really making any money. But you still have to pay tax on the interest.
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Re: Capital gains may be illusory.

Post by gaspr »

SoninlawofGus wrote: 28 Apr 2017 13:24
gaspr wrote: 28 Apr 2017 13:10
But the entire gain is an illusion. Using the Bank of Canada's inflation calculator, $10000 in 1980 is equivalent to $30492 in 2017 dollars. I am being taxed on inflation. It does not seem fair that CRA gets to raise the tax brackets by the rate of inflation, but we investors can not raise our ACBs by the same rate.
But that's just a bad investment, so bad that I think it defeats the hypothetical argument. In US dollars, $10,000 put into SPY on Jan. 1, 1980 is worth almost $240,000 now.
I agree it's a bad investment. But getting taxed on it makes it much worse.
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Re: Capital gains may be illusory.

Post by Chuck »

gaspr wrote: 28 Apr 2017 13:10 Is this a reason to perhaps harvest gains sooner rather than later? Am I doing the math correctly?
It's hard to say if it's better to harvest gains sooner. The thing is if you harvest gains, pay tax, then re-invest you've got less capital to grow. So in your example, say in 1985, the stock is worth $15K. You sell for $15K, pay tax on $2500 (50% of your $5K capital gain say at 50% rate - so $1250) and then re-invest the remaining $13.75K back into the company. Repeat every 5 years. By 2017 who is farther ahead?
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Re: Capital gains may be illusory.

Post by longinvest »

gaspr wrote: 28 Apr 2017 13:10 Hypothetical question. Say I purchased $10000 worth of shares of a company in 1980. This company never paid dividends, only repurchased shares or reinvested profits. Today, I want to sell and my shares are now valued at $30492. This is a capital gain of $20492 of which 50% would be taxable as regular income.

But the entire gain is an illusion. Using the Bank of Canada's inflation calculator, $10000 in 1980 is equivalent to $30492 in 2017 dollars. I am being taxed on inflation. It does not seem fair that CRA gets to raise the tax brackets by the rate of inflation, but we investors can not raise our ACBs by the same rate.

Is this a reason to perhaps harvest gains sooner rather than later? Am I doing the math correctly?
Gaspr,

First, one would have needed a pretty lousy investment to get a nominal 3% annualized gain from 1980 to 2017. Just for reference, here are the annualized total returns (with reinvested dividends/interest) on a few common assets during the period, according to The Stingy Investor Asset Mixer:
  • 3-month Canadian T-bills: 5.9%
  • Short Canadian Bonds: 7.8%
  • All Canadian Bonds: 8.9%
  • TSX Composite: 9.0%
  • S&P500: 12.0%
  • MSCI EAFE: 9.5%
OK, a part of total return was due to regular dividend and interest payments and only part of the return was due to cumulative capital gains. But, one should not forget to look at the entire picture.

Second, the tax is only applied to 50% of the capital gain. This more or less offsets the fact that part of the gain served to match inflation. If you take the TSX composite, for example. It had a total annualized return of 9%. We know that 3% of gains covered inflation. Assuming that dividends averaged 3%, that leaves an additional 3% of capital gains. By taxing 50% of the 6% in total capital gains, the government ends up not taxing the inflation adjustment. OK, I've simplified and rounded numbers, but you get the idea. It's not perfect, but it's good enough:
longinvest wrote: 24 Mar 2017 09:53
kcowan wrote: 24 Mar 2017 09:32 I think the problem is that politicians want something dumb enough for them to understand.
Yes. But, it's not such a bad thing, when you think about it. If it's dumb enough for politicians, it should be dumb enough for lots of people. As long as it's good enough (like the current 50% inclusion rule), I won't complain. It's the KISS principle (Keep it simple, stupid).
Third, it is not a good idea to harvest the gains sooner; it leads to compounding taxation (very bad).
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Re: Capital gains may be illusory.

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@longinvest Very good explanation. Thank you.
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Re: Capital gains may be illusory.

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longinvest wrote: 28 Apr 2017 13:36 Third, it is not a good idea to harvest the gains sooner; it leads to compounding taxation (very bad).
It's pretty much a wash. You gain a little by holding for the long term but when you do pay the tax you may end up with unintended consequences such as moving into a higher tax bracket or a claw back of OAS.
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Re: Capital gains may be illusory.

Post by longinvest »

deaddog wrote: 28 Apr 2017 14:10
longinvest wrote: 28 Apr 2017 13:36 Third, it is not a good idea to harvest the gains sooner; it leads to compounding taxation (very bad).
It's pretty much a wash. You gain a little by holding for the long term but when you do pay the tax you may end up with unintended consequences such as moving into a higher tax bracket or a claw back of OAS.
Deaddog,

By simply holding, instead of selling, one can avoid capital gain taxes and related OAS clawback. One could also delay OAS to age 70, unwind the taxable account in the interim at low tax rates, and move assets into the TFSA.

It would really be silly for a young or middle aged investor to harvest capital gains just to pay taxes earlier at the maximal tax rate and compound them. We don't even know if a future government wouldn't eliminate the clawback on OAS payments, like a past government added it.
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Re: Capital gains may be illusory.

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longinvest wrote: 28 Apr 2017 14:40 Deaddog,

By simply holding, instead of selling, one can avoid capital gain taxes and related OAS clawback. One could also delay OAS to age 70, unwind the taxable account in the interim at low tax rates, and move assets into the TFSA.

It would really be silly for a young or middle aged investor to harvest capital gains just to pay taxes earlier at the maximal tax rate and compound them. We don't even know if a future government wouldn't eliminate the clawback on OAS payments, like a past government added it.
Longinvest;

I've don't let the tax tail wag the investment dog. Too many uncertainties about what future governments may or may not do.

As a momentum investor/trader, I usually sell stocks that stop performing.

I learned my lesson with Nortel. I didn't sell because I didn't want to incur sizable capital gains taxes. When I finally sold I had minimum tax to pay but had let a sizeable windfall slip away. Lesson learned; Take what the market gives you and cough up whatever tax is owed.
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Re: Capital gains may be illusory.

Post by ig17 »

Charlie Munger:

"Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work."
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Re: Capital gains may be illusory.

Post by kcowan »

This would be a useful addition to finiki, applying to mutual funds and ETFs when compared to individual stock investing and also growth stocks that do not pay dividends.
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Re: Capital gains may be illusory.

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ig17 wrote: 30 Apr 2017 21:52 Charlie Munger:

"Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work."
Actually the tax you pay is only on 1/2 of the capital gain. Over 30 Yr period the difference still adds up but again when you eventually cash in the additional income you claim may cause other consequences.
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Re: Capital gains may be illusory.

Post by ig17 »

deaddog wrote: 01 May 2017 11:11 Actually the tax you pay is only on 1/2 of the capital gain. Over 30 Yr period the difference still adds up but again when you eventually cash in the additional income you claim may cause other consequences.
The relevant number is the marginal tax rate on the total capital gain (not taxable capital gain). Ontario resident earning between 92K and 142K pays 21.7% MTR on the full amount of gain. Admittedly, this is a far cry from the 35% in Munger's example. But the overall logic still applies.
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Re: Capital gains may be illusory.

Post by gsp_ »

Top CG tax rate in the 2 most populous provinces is just shy of 27%, more than 3/4 of the way to Munger's 35% example.
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Re: Capital gains may be illusory.

Post by longinvest »

Deaddog,
deaddog wrote: 01 May 2017 11:11
ig17 wrote: 30 Apr 2017 21:52 Charlie Munger:

"Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work."
Actually the tax you pay is only on 1/2 of the capital gain. Over 30 Yr period the difference still adds up but again when you eventually cash in the additional income you claim may cause other consequences.
I like to look at the mathematics before making my own mind on such issues. Let's do it!

I invest $10,000 (once) and have a 15% capital gain every year for 30 years.

SCENARIO A

If I pay 25% in capital gain taxes every year (that's half of a 50% marginal tax rate), I end up with:

(1 + (.15 * (1 - .25)))^30 * $10,000 = $244,907

SCENARIO B

If I let gains compound and pay 25% in capital gain taxes at the end and lose an additional 15% as OAS clawback, I end up with:

(1 + ((1 + .15)^30 - 1) * (1 - .25 - .15)) * $10,000 = $401,271

SUMMARY

If I pay taxes every year, I get a total after-tax gain of $234,907. If I pay taxes at the end and experience OAS clawback, I get a total after-tax gain of $391,271.

In other words, paying taxes every year in order to avoid OAS clawback would rob me of ($391,271 - $234,907) / $391,271 = 40% of my after-tax gain.

As I wrote earlier: compounding taxes are very bad!
Last edited by longinvest on 03 May 2017 12:56, edited 5 times in total.
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Re: Capital gains may be illusory.

Post by longinvest »

One should not forget that the OAS clawback scenario is unlikely. Very few Canadian retirees get their OAS partially clawed back, and only a tiny portion of them get it fully clawed back. (Congratulations, Deaddog, if you're among them).

A retired couple won't get its OAS clawed back before accumulating over $150,000 in annual taxable income, thanks to retirement income splitting. Such a couple would also get additional non-taxable income (half of capital gains, 100% of return of capital, 100% of TFSA withdrawals). So, we're probably talking about a couple getting something like $250K per year in retirement income. That's not the typical Canadian couple!

Yet, even for such a couple, it doesn't make any sense, mathematically, to realize taxes every year, even if they were able to avoid OAS clawback because of it.
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Re: Capital gains may be illusory.

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Being a bit picky but senior couples cannot necessarily split income sufficiently as to equalize at $75k each. Only eligible pension income counts for income splitting. Spouse gets all her OAS while I do not. But your point is valid. OAS clawback is way overrated and can disproportionately influence decisions.
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Re: Capital gains may be illusory.

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AltaRed wrote: 02 May 2017 13:29 Being a bit picky but senior couples cannot necessarily split income sufficiently as to equalize at $75k each. Only eligible pension income counts for income splitting. Spouse gets all her OAS while I do not. But your point is valid. OAS clawback is way overrated and can disproportionately influence decisions.
Also, the maximum clawback would reduce OAS to zero, so it's not going to be 15% of any size amount, a cap should be applied to the calculation.
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Re: Capital gains may be illusory.

Post by IdOp »

longinvest, did you subtract $100k instead of $10k to get the gains? (It doesn't affect the difference in the gains, of course.)
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Re: Capital gains may be illusory.

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IdOp wrote: 02 May 2017 14:54 longinvest, did you subtract $100k instead of $10k to get the gains? (It doesn't affect the difference in the gains, of course.)
Good catch! I've fixed the calculations.
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Re: Capital gains may be illusory.

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longinvest wrote: 02 May 2017 13:03

I like to look at the mathematics before making my own mind on such issues. Let's do it!
......................


As I wrote earlier: compounding taxes are very bad!
Longinvest;
Thanks for the numbers. I see where I made errors in my calculations. GIGO. :oops:

It is too late for me now. The only saving grace is that by trading in and out of the market I have been lucky enough to significantly out perform the market so that now capital gains are not a major factor when making a trading decision.

I’ll agree that the longer you can defer tax the better, but don’t hold on to losers just to avoid paying tax.
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Re: Capital gains may be illusory.

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deaddog wrote: 02 May 2017 17:49 I’ll agree that the longer you can defer tax the better, but don’t hold on to losers just to avoid paying tax.
Nor fail to take outsized gains that defy gravity because of the tax tail. A number of memorable examples... Bre-X, Nortel, Tech stocks in general circa 1999,
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Re: Capital gains may be illusory.

Post by StuBee »

But...

What if the return is a more reasonable 7.5% per year and CG crystalization on an annual basis results in more favorable taxation since it is less likely to be pushed into the maximum MTR. IOW a 50% MTR (pessimistic??) for the once only CG and a 38% MTR (optomistic perhaps...) for the annual CG.

Annual CG= (1+ (.075 * (1 - .19)))30 * 10 000$ = 58666$

At end CG= (1+ .075)30 * (1 - .25) * 10 000$ = 65662$

The difference is now (65622-58666)/65622 * 100 = 10.6%. It would be closer to 0% if we chose to also claw back the OAS...

I admit that this comparison may excessivly favor the annual CG scenario. However, so much can happen over a thirty year period that in all likelihood some sales will take place inspite of the best intentions of the "buy and holder". This will further reduce the difference between the two scenarios.

I prefer the argument that unrealized CG's permit increased dividends since the virtual tax liability is producing a portion of them.

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Re: Capital gains may be illusory.

Post by kcowan »

AltaRed wrote: 02 May 2017 13:29Being a bit picky but senior couples cannot necessarily split income sufficiently as to equalize at $75k each. Only eligible pension income counts for income splitting. Spouse gets all her OAS while I do not. But your point is valid. OAS clawback is way overrated and can disproportionately influence decisions.
This would seem to favour putting the pure capital gains in your portfolio, and the poorer performers like ETFs and dividend stocks in your wife's portfolio, strictly from an after tax yield perspective.
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