I’m in my 30s and I own about $300,000 worth of Shopify Inc. shares, which I received as part of my compensation before I left the company in 2019. The shares have an unrealized capital gain of $210,000 and account for nearly 30 per cent of my portfolio, which is worth slightly more than $1-million. I’m wondering if I should reduce my Shopify position and put the money into low-cost index funds, but I also don’t want to bear the full capital gains tax, as my annual income is about $130,000 and my marginal tax rate in British Columbia is about 40 per cent. What’s the most tax-efficient way to do this? Do I have to wait until a gap year when I minimize my income?
I probably don’t need to tell you this, but you would have been better off trimming your Shopify SHOP-T position before the price plunged about 80 per cent from late 2021 to mid-2022. Nobody knew such a steep drop was coming, of course, but based on some back-of-the-envelope math, I’m guessing Shopify accounted for about 50 per cent your portfolio at one time. That’s far too much weight to give any stock, let alone a tech company with an outsized price-to-earnings multiple.
The silver lining is that you learned an important lesson about the benefits of diversification. With that in mind, let me offer a few comments to help you decide your best course of action.
First, having 30 per cent of your portfolio in a single stock is better than 50 per cent, but it’s still way too high for proper diversification. As a rough rule of thumb, I aim to allocate a maximum of about 5 per cent to each individual stock, but I allow some wiggle room for companies on the conservative end of the spectrum. For example, the largest holding in my personal portfolio is Fortis Inc., with a weighting of about 7 per cent. But as a regulated utility with a long history of increasing its dividend, it has a lower risk profile than a tech stock like Shopify.
Second, although your timing could have been better, it could also have been a lot worse. Shopify shares have more than doubled from their lows last fall, which makes this an opportune time to consider trimming your holdings. True, Shopify could continue to rise, in which case you might kick yourself later. But it could also head lower again. Since you don’t have a crystal ball, the only thing you can do is control your risk.
Third, although nobody likes paying taxes, keep in mind that capital gains qualify for a significant tax reduction relative to other sources of income. Specifically, only half of capital gains are added to your taxable income, which means – for someone in British Columbia earning $130,000 – the effective marginal tax rate on capital gains is 20.35 per cent. The effective capital gains tax rate increases in small increments as income rises, topping out at 26.75 per cent for someone with income of more than $240,716.
How much capital gains tax would you have to pay? Well, if you were to sell, say, two-thirds of your Shopify shares for $200,000, you would realize a capital gain of $140,000 (two-thirds of your total unrealized gain of $210,000). This would add $70,000 to your income, and increase your tax bill by about $30,000. All else being equal, your Shopify weighting would fall to about 10 per cent of your portfolio – still not ideal, but a big improvement over 30 per cent. I’m using round numbers for illustration purposes; try the detailed Canadian income tax calculator at TaxTips.ca to run some different scenarios.
However, there may be ways to reduce the tax hit. If you have capital losses in the current year, for example, you can use them to offset your capital gains. Many investors employ a strategy called tax-loss selling, in which they sell a losing stock specifically for this purpose. Just be careful not to repurchase the losing stock within 30 days of the sale, or the sale will be considered a “superficial loss” that cannot be claimed for tax purposes. You can also carry forward any unused net capital losses from previous years to reduce your capital gains. Net capital losses can also be carried back, but only up to three years.
Another possibility, as you mentioned, is to wait until a year when you expect to have reduced income. If you were planning to take a hiatus from work to travel, for example, that would be an ideal time to trigger capital gains as the tax hit would be reduced. The risk is that Shopify’s shares could fall in the meantime. Whether you decide to sell now or later, putting the proceeds into index funds makes sense, as it will enhance the diversification of your portfolio.
There are a lot of moving parts here, and your decision should take into account proper portfolio diversification, taxes and your comfort level with Shopify’s business outlook. Consider any capital gains tax the price you have to pay to achieve proper diversification for the many decades of investing ahead of you.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.