Taxable Income, Book Value, Market Value and Investment Returns: What Does It All Mean?

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As investors gather their tax information for the 2019 tax season, we thought it would be helpful to address two recurring questions that come up this time of year.

“My investment returns were strong last year, but my accountant doesn’t seem so sure as I don’t have a lot of taxable investment income to report. How did I really do overall?”

This common comment shines a light on the relationship between a portfolio’s investment return and what qualifies as taxable income. It is helpful to approach each concept separately to understand their connection.

Your portfolio’s investment return represents the amount of money your portfolio made over a given period, expressed in percentage terms. There are four possible contributors to investment return: dividends, interest, net realized appreciation and net unrealized appreciation.

Dividends are paid to shareholders (i.e. owners of stock) out of the profit earned by a corporation.  Interest is paid to owners of fixed income investments such as Guaranteed Investment Certificates (GICs), corporate bonds and government bonds. As a lender to a corporation, financial institution or government, you receive periodic interest from the borrower. Interest and dividends are generally received as a cash deposit directly to your investment account, thereby contributing to your portfolio’s overall growth.

Realized appreciation — often referred to as capital gains — is earned when an investment is sold for more than its purchase price. Capital losses are triggered when investments are sold for less than their purchase price. Realized gains and losses in a given calendar year are netted against each other to arrive at your net realized gain or loss position for the year. Remember, this figure is the net gain or loss for all investments in your portfolio that were sold during the year.

Unrealized appreciation represents the net increase or decrease in value for all investments in your portfolio that you still owned at year end (i.e. the investments that were not sold during the year).

If you add up all dividends, interest, net realized and unrealized appreciation (or depreciation), you arrive at the total amount of money you made (or lost) during the year.

So how does this relate to what you owe in tax?

Here are important differences between investment return and taxable income:

  • First, unrealized appreciation in your portfolio is not taxable. Simply, the increase in value of investments that have not yet been sold remains tax free until such time as those investments are actually sold and become realized gains.
  • Second, while realized appreciation is taxable in the year in which the investment is sold, the appreciation may have occurred over the course of several years. For example, if you purchased one share of XYZ Corp. in 2015 for $100 and sold that share in 2019 for $300, you would have a realized capital gain in 2019 of $200 ($300 sale price less the $100 cost). Remember though that the share may not have appreciated by the full $200 in 2019 — it’s possible that XYZ was worth $300 at the start of 2019 and was sold later in the year for the same price.  In this scenario, your capital gain for tax purposes from XYZ is still $200 in 2019, but your investment return on XYZ for 2019 would be 0% as it did not appreciate during the year (it appreciated by the $200 at some point between 2015 and 2018).
  • Third, according to CRA rules, only 50% of realized investment gains are taxable. In the example above, only $100 of your $200 gain on XYZ would show up on your 2019 tax bill.
  • Fourth, returns on investments held inside registered accounts (RRSPs, RRIFs, TFSAs, etc.) are not taxable, regardless of whether they come in the form of dividends, interest or realized appreciation. However, if you withdraw money from your RRSP or RRIF, the withdrawal is treated as taxable income to you in that calendar year. Importantly, the timing of your withdrawal would likely have little to do with the investment performance of your registered account.

In summary, clients can be surprised that their taxable income is low when their investment returns are high.  As illustrated, this may simply be because a significant portion of their investment return came from unrealized — not taxable — appreciation.

Conversely, a client may ask why they have a significant tax liability in a year where their portfolio did not perform well. The explanation may be that investments with significant capital gains were sold that particular year, resulting in realized taxable gains. If the gains were largely earned from prior years’ appreciation, then the investment returns were earned in years that are different from the year in which the tax was triggered by selling.

“I am trying figure out how much money I have made on my investments. Can I just compare the book value of my investments to their current market value on my investment statement?”

The answer: probably not.

There are two primary reasons why comparing market value to book value is an imperfect method in determining how your investments are performing:

  • First, book value generally represents your original purchase price for an investment plus or minus certain adjustments made over the investment’s life. Book value is often adjusted for various types of distributions, such as non-taxable returns of capital or taxable distributions received, causing accounting book value and your original purchase price to drift apart the longer you hold the investment. For example, taxable distributions received on investments in pooled funds (such as those managed by Bridgeport) are generally added to book value on an annual basis to ensure clients avoid double taxation when they sell their pooled fund units.
  • Second, it is problematic to compare the total book value and total market value on a consolidated basis because both only reflect current holdings. As portfolios evolve, investments are often sold, thereby removing their related book value and market value from the consolidated view. The investments that were sold are then either held as cash or replaced with new investments which will initially have a book value equal to their market value. In either case, the portfolio’s consolidated difference between book value and market value has forever changed with the sale of the investment. If, for example, the investment that was sold had a market value well in excess of its book value, then the spread between the remaining portfolio’s consolidated market value and book value will have contracted, although the change would in no way be indicative of worsened portfolio performance.

Instead of comparing book value and market value, the best way to assess the investment performance of your portfolio is to calculate rates of return based on the change in your portfolio value over a given period while accounting for contributions and withdrawals that may have been made. Fortunately, Bridgeport performs this calculation quarterly for our clients on year-to-date, one, three, five and seven year intervals, and on a since-inception basis. These consolidated portfolio investment performance calculations may be found on page four of your quarterly Bridgeport investment report.

Please feel free to contact us should you have any further questions on any of these topics.