My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, October 3, 2011

Stocks with Capital Gains- To Give unto Ceasar or not

I have always been confounded by people who are reluctant to sell a stock that has increased in value because they have to pay capital gains tax. It goes without saying, that income taxes can have a significant impact upon your portfolio’s value over time. Obviously, the longer you can avoid paying income tax, the greater capital you will have at work. However, some people are so adverse to paying income tax on their stock gains, that they are paralyzed from making a sound investment decision.

The underlying question that I will try and address in this blog is: how much a factor should the income tax on your capital gain be when selling shares, if you cannot find a viable replacement equity? I suggest it should be a non-factor.

It should be noted that this blog will revolve around the sale of individual stocks, not mutual funds; as some corporate class funds can be utilized to defer capital gains. I have also not considered an equity monetization strategy based on the assumption that for most readers, monetization is not practical, as I have only seen it used one or twice in all my years practice.

While writing this blog, I came across an interesting statement in Sacha Peter’s Divestor Blog (a favourite on my blog roll) that was right on topic. In his blog “Links and after-tax calculations,” Sacha states that he finds it personally very frustrating to hold onto investments that have appreciated beyond what he considers to be its fair value, but he is "prevented" from selling these stocks because of the capital gains taxes that he would incur.

I commented on Sacha’s blog that I did not really understand his comment. I stated that "Capital gains tax in Canada is 23% or less and to me, that is not an onerous rate. Yes, one never wants to pay tax, but I see people hold onto stocks because they don’t want to pay the tax on stocks that have appreciated past their fair value and the stock sharply corrects. To me, 23% or less is not a large detriment to take a profit when you compare it to the 46% you pay on interest and employment income and compare it to the potential true cash loss you may incur by holding a stock that should be sold.”

Sacha’s response to my comment was “I agree with you from a practical perspective. Academically I outlined a scenario in my previous post that illustrates the situation.” Sacha then provided the  example below which follows the conventional wisdom in regard to selling stocks. This conventional wisdom is succinctly expressed by Greg Forsythe of the US security firm Schwab; "Sell an existing holding if another stock compatible with your risk tolerance is available that provides higher return potential after subtracting any taxes and transaction costs in executing the swap".

Sacha says “Let’s take a hypothetical investment between two securities. Security ABC is a perpetual bond, paying $10 per unit. Security DEF is a perpetual bond of the same issuer, with substantively the same seniority/call provisions as ABC, paying $8 per unit. Your marginal rate (to make the math easy) is 50%.

Let’s pretend you bought ABC for $80, netting a pre-tax yield of 12.5% and after-tax yield of 6.25%. If ABC is now trading at $100/share, what price does DEF have to be in order for the decision to be a net positive? Assume frictionless trading costs, and capital gains taxes are payable immediately upon disposal. For this to be a break-even transaction, your $95 ($100-$5 tax) in after-tax dollars must equal the income of the prior portfolio, mainly $10. $10/$95 = 10.53%, so you must buy DEF below $76/unit in order for your transaction to make financial sense."

Sacha continues "I will again completely agree that this academic exercise is of little use in the grey and fuzzy world of investing in that you never quite know whether you got fair value correct and whether the geniuses on the other side of the computer screen think their idea of fair value is higher or lower.”

Just to be absolutely clear, I am not picking on Sacha. I asked him if I could use his response in this blog, I am just using his response for discussion and illustration purposes. In the above response, Sacha compares two securities based on coupon rate and unrealized gains. His example requires comparable alternatives and is not necessarily his analysis for the sale of a single stand alone stock.

Now, I am not the academic or mathematician that Sacha is, but I guess my issue with conventional wisdom is should one not consider the valuation of a stock and the net proceeds that will be achieved after-tax instead of always looking for a break even alternative or stock with a potentially higher return (i.e.: an alternative may not always be available when you wish to sell a stock and thus, should the income taxes then not become a moot point?).

To illustrate, if I bought Nortel at $50 and sold it at $100, since I thought $100 was fair value, I would have had approximately $88 in my pocket after-tax. Now, look at the many Canadians who held onto Nortel as it rose in price. As I recall, many people were concerned Nortel was way overvalued, but they did not sell their shares because they did not want to pay the large income tax bill associated with their gains. Following with the above example, when Nortel was $130, you could have sold and realized approximately $112 after-tax. At $115 you would have realized $100 after-tax and, as noted above, at $100 you would have realized approximately $88 after-tax.

However, many Canadians held on and did not sell until the $60 range or less. At $60 you would have realized approximately $57 after-tax. Your net after-tax loss of not selling at a pre-determined fair value of $100 was $30 or more, even after paying the income tax.

It is my suggestion that once you feel a stock has hit full value, place a stop-loss order at that pre-determined value and look past the paralyzing income tax decision to your after-tax proceeds and return. Deal with what you will do with those funds as a standalone question.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.


  1. It must be nice to be rich and own large amounts of shares in a company; you can undertake the monetization strategy noted in the blog and get out of capital gains. The rich get richer

  2. Sam, I am not sure the rich get richer, but it is at least a case of deferring the tax on a gain that most people cannot and managing the timing of your capital gain.

  3. "Sam" is clearly a troll. In my humble opinion, such comments should be simply deleted and not responded to. Don't feed the trolls.

    And if a response must be made, I would simply point out that the poor have been getting richer too over the last 200 years of capitalism.

    Compared to a millionaire of 100 years ago, the poor today have access to cleaner, better, food of greater variety. Better medicine and even better education are also within reach.

    Items that were luxury goods only 30 or even 10 years ago are now withing reach of almost anyone: car safety systems, large screen TVs, powerful computers, hi-fidelity audio equipment, kitchen equipment, etc.

  4. One thing that is always left out of these calculations is the fact that sooner or later, you will pay tax on the gain. It's a sunk cost. The choice is between paying the tax on the gain today, or paying the tax on the gain a number of years down the road (assuming the gain does not evaporate in the mean time), so the cost of realizing the gain now is the difference between the present value of the tax liabilities, which might be substantially less than the tax liability today alone.

  5. Andrew, I agree 100%. However, as you note "assuming the gain does not evaporate in the mean time" is the essence of my blog. If you feel the stock still has room to move, I am with you, but if you think it is full value, I say forgot about the present value and just sell the darn thing.

  6. I am confounded by your opening paragraph, where you (correctly) talk about capital gains taxes, but then shortly after, switch to discussing income taxes. Not sure why you are introducing income taxes into an article about capital gains taxes.

  7. Anon, I would hope after reading the blog you would be considering whether you should sell stocks with capital gains and not worrying about why I was introducing the term income taxes instead of capital gains taxes. But since you deem it worthy of a comment I will respond.

    If you read the Income Tax Act, there are various sections and subsections for taxing different types of income and the taxation of capital gains are just one section of the Act. The everyday reality is the terms are used interchangeably, but if you want to be "correct" as you say, there is then no such thing as capital gains tax, there are income taxes only. No where on your income tax return does it say capital gains tax, it says income tax which is calculated by including taxable capital gains, employment income, business income etc. and applying income tax rates to the income earned.

  8. It all depends on the type of stocks you hold. Personnally I ony invest in large and sound dividend paying stocks with a history of dividend growth and hold on them. Thier market value fluctuates of course but since I ma a long term investor bull and bear markets are of little concern to me. If sell one of my stocks than has tripled or quadrupled in value over the years I not only have to pay capital gain tax but my dividend income also takes a haircut. Investment income is of paramount importance to me. I have come to the point where my capital is akin to a pension fund that generates the income that I need to live income. Market fluctuations don't bother me too much as lomng as my dividend income comes in regularly. During the 3008 crash I did not sell any stock at all and all my dividends continued to come in. My bottom line is that it all depnds on the type of stocks you hold and whether dividend income is a high priority for you. The Blunt Bean Counter may be right in some cases but not in my own.

  9. Anon, thanks for your thoughts and investing philosophy. Only one question, what happens when you have a blue chipper like Kodak which does not adapt and is no longer a blue chipper? I assume you still weed out one-time blue chippers on a consistent basis, as many of those have fallen from grace mightily.