What is tax-loss selling?
Tax-loss selling, often referred to as tax-loss harvesting, is a strategy aimed at minimizing or cancelling out capital gains. It consists of realizing a capital loss by selling a non-registered investment at a value below its purchase price. These investments can include stocks, bonds, mutual funds or ETFs that have declined in value throughout the year.
When capital losses are realized, they can be deducted from the capital gains generated in the same taxation year, thereby reducing the taxpayer’s tax burden.
Who can benefit from it?
This strategy is available to investors looking to decrease their capital gains tax liability by disposing of investments that have incurred losses by the year’s end.
Financial advisors can review investment portfolios along with a tax specialist to help identify those that have generated losses which could be offset by capital gains realized in the same tax year.
Key tax rules to consider
Tax-loss selling has specific rules to consider, including:
- The Income Tax Act (ITA) limits the amount of realized loss that can be considered a tax-deductible capital loss to 50%. This capital loss can potentially be used to reduce the calculation of taxable income. If no capital gains are realized in the current year, capital losses can be carried back to the previous three tax years or carried forward indefinitely.
- The ITA also includes the “superficial loss" rule, also known as the "30-day rule." This rule prevents an investor or their affiliated persons from deducting a capital loss realized as a result of the sale of a security when the same security is repurchased within 30 days before or after the sale [1].
After this period, investors are allowed to repurchase these same securities without nullifying the capital loss.
Using ETFs in a tax-loss strategy
The “superficial loss” rule doesn’t necessarily restrict investors’ options. For instance, they can reinvest the security sale proceeds in ETFs within the same asset class or sector to maintain a similar exposure.
To ensure these transactions are not considered identical to the initial investment sold at a loss, they must, however, meet specific criteria and conditions. This makes the expertise of a financial advisor crucial. An eligible ETF is considered “materially different” from your original position, so it doesn’t invalidate the capital loss.
100 shares
↓
Investor purchases 100 shares at $10/share = $1,000.
100 shares
$7
August
↓
Share price dips to$7.
Loss
-$300
August
↓
Investor sells 100 shares at $7/share (= $700) to realize a deductible loss of $300 ($700 - $1,000).
100 units
$7
August
↓
To remain invested in the same sector, investor acquires units of an eligible ETF at $7/unit.
ETFs offer a low-cost and flexible way to gain exposure to an asset class or sector after selling a security below its purchase price. Among other benefits, they also facilitate enhanced portfolio diversification.
Get expert advice
In the realm of tax strategies, each investor’s situation is unique. Before planning or implementing a tax-loss selling strategy, it’s essential for investors to consult with their tax specialist and financial advisor.
For example, for a tax loss to apply to the current tax year, the financial advisor will ensure that the transaction settles by December 31. It’s important to note that settlement dates typically occur two business days after initiating a sale.
The possibility of realizing capital losses by selling and acquiring similar assets offers the additional benefit of remaining active, while having the opportunity to rebalance and diversify your portfolio.
[1] The ITA specifies that the purchase period is the “period that begins 30 days before the disposition and ends 30 days after that disposition."
Learn more: NBI Exchanged-Traded Funds
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