It’s particularly easy for investors to make costly mistakes during the year-end tax-loss selling season. That’s because the lure of a lower tax bill can be a temptation to dump high-quality stocks that are near the end of a downturn, and are set to move back up.

A similar pitfall exists during the end-of-the-year rush to take advantage of certain tax shelters, including charitable donations. In our view, you should be as selective about giving money to charity as you are about buying stocks. In fact, bad charities tend to have something in common with bad stocks.

Examine a charity’s “business plan” before donating

Bad stocks devote much of their effort to promoting their stock prices, and overplay progress they make in their businesses. Similarly, bad charities devote the bulk of their budgets to fundraising and administration costs, while touting the limited charitable work they do.

The first thing to look at when evaluating charitable-donation tax shelters is the proportion of a charity’s budget that goes to fundraising and administration. (You can get financial information for Canadian registered charities through the Canada Revenue Agency’s web site.)

You also need to look at what you might call the charity’s “business plan.” Does it make sense? Is the charity equipped to pursue its objective in an effective, efficient manner? If not, other charitable organizations may be able to put your donation to better use.

One sound investing rule is that if you have any doubts about the integrity of a company’s insiders, you should stay out of the stock. You should apply the same rule to tax shelters, including charities. Some charities “cook the books” to make themselves look more deserving.

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For instance, one seemingly reputable charity once revealed that it had cut the proportion of its budget that it devotes to fundraising by simply reclassifying part of its telemarketing costs as a public-education service.

Donating stocks is a great way to maximize your charitable-donation tax shelters

There is now a way to donate funds you hold in shares of publicly traded companies that not only maximizes the donation for the charity, but lets you pay no capital gains taxes. This change came into effect as a result of the May 2006 federal budget.

This amounts to a double benefit for investors. When you donate stocks or mutual funds directly to a charity, you get a tax credit on the entire value of the shares. Plus, any capital gains you recognize on these investments are tax free.

Let’s look at an example: say you bought 1,000 shares of Royal Bank at $20 per share, and when you decide to donate your holding, the stock has climbed to $50.

If you decide to sell the shares first and donate the proceeds to charity, your profit, or capital gain, on the sale would be $30,000.

You only pay tax on 50%, or $15,000, of your capital gain. If you live in Ontario, say, and are in the highest income-tax bracket, your tax rate would be 46.41%, so you would owe $6,962 in capital-gains tax, leaving you with a total donation of $43,038, for which you would receive a tax credit of roughly $19,974.

However, if you are in the same tax bracket and donate the shares directly, you will receive a tax credit on the entire value of the shares at the 46.41% tax rate, for a total of $23,205, and at the same time avoid paying taxes on the accumulated capital gains. And the charity would receive the entire value of the shares ($50,000).

If you have investment questions about tax shelters or other investment issues, or if you’d like to ask me about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.