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Tax Loss Harvesting

Tax Loss Harvesting: Make The Most of Investment Losses

By Michael Callahan | December 8, 2017

What can you do about those investments in your portfolio that aren’t exactly performing as you had expected? If you’re like many others, you’re probably thinking, “I’ll just hold it until it goes back up to where I bought, and then I’ll sell it.”

Indeed, this seems to be a common strategy. Why? Mostly because, if we sell an investment after it has declined, we must accept the fact that we have a loss. And not just a “paper loss,” because after selling, it’s real. As a part of this process, we must also admit to ourselves that we’ve made a decision that hasn’t worked out as planned. Accepting this reality is actually very difficult for most investors.

However, on the other hand, if we don’t sell an investment when it’s down, then we haven’t really lost anything. And, correspondingly, if it rebounds at some point in the future, then we haven’t really made a bad investment decision after all. That thought process is very appealing, as our egos remain intact and unscathed.

Tax Loss Harvesting

As emotionally comforting as it may be, holding on to losing investments is typically not an optimal investment strategy, and not a recipe for success.

Believe it or not, there is a silver lining to selling investments at a loss. Tax loss harvesting provides you with a means of turning your investment losses into something useful: a powerful tax-saving strategy. As long as you follow a few basic rules, you can unload your losing investments and pave the way for some future tax-free capital gains by taking advantage of a strategy known as tax loss harvesting.

Before we dig into specifics, we must note that this strategy is applicable only in taxable accounts. Remember, there are no tax consequences of capital gains and losses in TFSAs, RRSPs, or other registered accounts. As such, tax-loss harvesting is applicable only in non-registered accounts.

How It Works

As a strategy, tax loss harvesting is premised on rule that capital losses can be used to offset capital gains. This strategy provides you with an opportunity to make good use of losses – by using them to neutralize taxes owing on other transactions where capital gains have been generated.

But, what if you have no capital gains? This is where the “harvesting” part comes in. If you currently have no realized capital gains in your portfolio, your capital losses can be:

  • carried backward up to three years;
  • carried forward indefinitely.

Note that, to the extent possible, capital losses must be used to offset capital gains in the year the losses and gains are realized. That is, it’s only the net loss that can be harvested and carried forward or backward to other years.

For example, if you have a $10,000 capital loss and a $3,000 capital gain this year, the loss must first be applied to the gain, and the resulting net loss of $7,000 can then be carried forward or backward to other years. You cannot elect to pay taxes on the $3,000 gain and carry the full $10,000 loss to other years.

To carryback a capital loss, you must complete Form T1A – Request for Loss Carryback. You do not have to file an amended return for the year to which you want the loss applied.

Note that any losses reported on form T1A will lower your taxable income for that year, resulting in either a refund or a reduction of your taxes owed. However, this adjustment does not change your net income, nor does it change your eligibility for benefits. That is, you cannot obtain retroactive government benefits by carrying a capital loss backward to a previous year.

Tax Trap #1: Superficial Loss Rule

When a capital loss is deemed to be a superficial loss, the loss cannot be immediately realized and used to offset a capital gain. Instead, the loss must be added to the adjusted cost base (ACB) of the property, and then can be recognized upon final disposition.

According to the CRA, a superficial loss occurs when you sell capital property at a loss, and:

  • you, or a person affiliated with you, buys, or has a right to buy, the same or identical property (called “substituted property”) during the period starting 30 calendar days before the sale and ending 30 calendar days after the sale; and
  • you, or a person affiliated with you, still owns, or has a right to buy, the substituted property 30 calendar days after the sale.

Some examples of affiliated persons are:

  • your spouse or common-law partner;
  • your TFSA or RRSP (or other registered account);
  • 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.

The superficial loss rule is one of the most common traps investors fall victim to, but it need not be. In fact, there are some straightforward and simple ways to avoid superficial losses. For example, if you’ve sold a Canadian equity mutual fund and realized a capital loss, but still want to maintain the same exposure to Canadian equities, you could buy a Canadian equity exchange traded fund (ETF) instead. This would allow you to maintain your desired weighting in Canadian equities, and yet avoid the superficial loss rules.

Tax Trap #2: Contributions In-Kind

Another tax trap to watch out for is the denial of capital losses on in-kind contributions. If you hold securities in a non-registered investment portfolio, you can make a contribution to your RRSP or TFSA by contributing those securities in-kind to your RRSP. Remember, an in-kind transfer is considered as a deemed disposition, which means a capital gain or loss is generated.

Unfortunately, gains and losses are not treated equally when it comes to in-kind contributions. If you have a capital gains, that gain is taxable and will have to be declared accordingly. However, if the in-kind contribution and deemed disposition triggers a capital loss, the loss will be denied. That is, you cannot claim a capital loss on an in-kind contribution.

In order to create a capital loss for tax loss selling purposes, you would have to first sell the investment in your non-registered portfolio, and then make the RRSP or TFSA contribution with the cash proceeds from the sale. However, note that if you re-purchase the same investment inside your RRSP or TFSA within the 30 days following the in-kind contribution, you will fall victim to the superficial loss rule, and your capital loss will be denied.

Bottom Line

Remember this: You don’t need to make your money back in the same place you lost it. Tax-loss harvesting can help you make the most of your losing investments by utilizing those losses to help offset gains generated elsewhere.

While tax minimization should be a goal for us all, it should not be the sole determinant when making investment decisions. Keep in mind that your own unique circumstances, including your risk tolerance, time horizon, and long-term investment goals, should always be taken into account when making adjustments to your portfolio.

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Michael Callahan