If there was a mantra for investing, it would be “buy low, sell high.” After all, that’s the goal, to make money. But that doesn’t always happen. 2022 has been a challenging year for markets with geopolitical tensions, supply chain issues, rising inflation and record central bank rate hikes around the world. Both the S&P 500 and Nasdaq are in bear market territory, meanwhile the Dow Jones is nearly there. A bear market is typically defined as a loss of at least 20% from recent highs.
Fortunately, there’s a way for investors to turn losses from their non-registered investments (eg. stocks, bonds, mutual funds, ETFs) into a tax advantage.
Tax-loss selling (or tax-loss harvesting) is a tax strategy where investors sell an investment trading at a loss to offset capital gain taxes elsewhere in their portfolio. Selling an equity to register a loss might sound counter productive, but it’s an excellent tool that can help minimize your tax burden.
It’s an especially important option to consider as we get closer to the end of the year with investors looking for ways to reduce capital gains taxes.
What Is Tax-Loss Selling?
Tax loss selling is when you sell an investment within a non-registered account for less than the adjusted cost base (ACB). The ACB is the book value you paid for the investment plus any expenses related to the purchase, which can include any fees or commissions.
Selling an investment for less than the ACB results in a capital loss. Investors can use that loss to offset a capital gain within a non-registered account in the current tax year. It’s also possible to carry back tax losses for up to three tax years or carry them forward indefinitely.
What Is an Example of Tax Loss Selling?
The inclusion rate for capital gains in Canada is 50%, which means that you have to include 50% of your capital gains as income on your tax return. This is then taxed at an individual’s marginal tax rate. For example, if an investor makes a $20,000 profit on the sale of a stock, half of that, or $10,000, is taxable income. If the investor is in the 26% tax bracket, the taxes owned on that gain would be $2,600.
In other words, Archie buys 100 shares of a bank stock, ABC Ltd., for $10 per share, resulting in a total investment of $1,000. After a few months, the stock price of ABC Ltd. falls to $5 per share, resulting in a $500 loss. Archie decides to sell his shares and take the $500 loss.
Archie has not necessarily lost conviction in bank stocks, he has just lost conviction in ABC Ltd., so he takes his remaining $500 and invests it in another bank stock, XYZ Inc. It performs well and he sells XYZ Inc. for a $500 gain.
Archie would normally have to pay capital gains taxes on that $500, but because of the $500 he incurred in capital losses from his investment in ABC Ltd., he won’t owe any capital gains on this investment come tax season.
Can Tax-Loss Harvesting Be Used to Offset Losses in Registered Accounts?
The joys of investing in registered accounts like a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP) means that any capital gains are tax free. However, because you do not pay tax on investable income inside any registered accounts, this means you can’t use capital losses incurred in these accounts to offset gains in other accounts.
What Other Things Should I Know About Tax Loss Selling?
When you sell an investment and trigger a capital loss, the superficial loss rule kicks in. According to the rule, investors cannot deduct the capital loss if they buy an identical security within 30 days of the settlement date. The superficial rule also applies to options or a right to buy the security that was sold.
Going back to our previous example, Archie cannot sell ABC Ltd. for a loss and hope to claim the capital loss and then immediately repurchase the same stock at a lower price. The 30-day superficial loss rule is designed to prevent investors from taking advantage of the system in order to lower their income tax.
To that end, affiliates cannot make the purchase either. An affiliate, according to the CRA is:
- You and your spouse or common-law partner
- You and a corporation that is controlled by you or your spouse or common-law partner
- A partnership and a majority interest partner of the partnership
- A trust and its majority interest beneficiary (generally, a beneficiary who enjoys a majority of the trust income or capital) or one who is affiliated with such a beneficiary
Instead of waiting 31 days to repurchase JKL, Archie could purchase another security with similar exposure, such as an ETF, immediately after the sale of JKL. Archie could then switch back into JKL after the 30-day period if he wishes.
Year End Deadline
It is important to note that investors who use tax-loss harvesting to reduce their tax obligation for the current tax year need to keep in mind the settlement cycle of the investment instrument they are trading. Typically, most securities settle three business days after a sale is made. You can take advantage of tax-loss selling all year long, but in order to realize any losses, the securities must settle before the year-end.
In summary, it doesn’t matter what tax bracket you’re in, tax-loss selling is a simple and effective tax strategy for helping mitigate your tax burden if used appropriately.
About Evolve ETFs
With over $3.5 billion in assets under management, Evolve is one of Canada’s fastest growing ETF providers since launching its first ETF in September 2017. Evolve is a leader in thematic ETFs and specializes in bringing disruptive innovation ETFs to Canadian investors. Evolve’s suite of ETFs provide investors with access to: (i) long term investment themes; (ii) index-based income strategies; and (iii) some of the world’s leading investment managers. Established by a team of industry veterans with a proven track record of success, Evolve creates investment products that make a difference. For more information, please visit www.evolveetfs.com.
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This is for information purposes only and should not be construed as tax advice. Given that each investor’s tax situation is unique, please consult a qualified tax advisor.