In our last post, we discussed in-kind contributions. Many investors, who are otherwise unable to make a TFSA and RRSP contributions, may be able to contribute existing non-registered investments to their RRSP accounts, thereby getting a tax deduction in the process. However, it’s important to be careful of a couple of potential tax traps when making in-kind contributions – superficial loss rules, and the denial of capital losses.
The first trap, as discussed in our prior post, is that capital gains and losses are not treated equally. That is, when making in-kind contributions, gains are taxable, and yet losses are denied. For this reason, it is generally not advisable to make an in-kind contribution with an investment that is in a loss position. Rather, it’s generally better to first sell the investment in your non-registered portfolio, and then contribute the cash.
So why not just buy the same investment again, as soon as you’ve invested the cash proceeds into your RRSP? This question leads us to the next trap.
Before we get into the superficial loss rule works, and how to avoid it, let’s first define it.
What, exactly, is a superficial loss? When a capital loss is deemed to be a superficial loss, it means that the loss cannot be immediately realized and used to offset a capital gain.
How is a superficial loss genrated? A superficial loss applies when you incur a loss on the disposition of capital property (such as a stock, bond, mutual fund, or ETF), and the identical property is acquired by you or an affiliated person within the period of 30 days before and 30 days after the 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.
As you can see, if you sell an investment in your non-registered account at a loss, then contribute the cash to your TFSA and immediately buy the same investment, you will not be able to claim that loss. That is, it will be deemed a superficial loss, and it will be denied.
How Can You Avoid a Superficial Loss?
Although the superficial loss rule is one of the most common traps to which investors fall victim, it need not be. In fact, there are some straightforward and simple ways to avoid superficial losses.
For example, you could just wait the 30 days, and then re-acquire the property. However, this solution presents another problem. Waiting those 30 days could prove to be a costly mistake if the investment increases significantly in value while you’re sitting on the sidelines waiting to get back in. For that reason alone, although holding cash for 30 days and waiting to re-acquire your investment would indeed allow you to avoid the superficial loss rules, it is generally not an optimal strategy.
A better strategy is often to acquire similar, but not identical, property. The language here is very specific, and in order to be deemed a superficial loss, the identical property must be acquired within the 30 days before or after the sale. So as long as the property is not identical, the superficial loss rules will not apply. For example, if you’ve sold the ABC Canadian equity fund and realized a capital loss, but still want to maintain the same exposure to Canadian equities, you could buy the XYZ Canadian fund instead. In most cases, you’ll be able to find substitute funds with a vast majority of the same holdings, and in similar proportions, yet they key is that they are not identical. This would allow you to maintain your desired weighting in Canadian equities, and also avoid the superficial loss rules.
Of course, this strategy may not always be available, for example in the case of individual stocks. But even then, you could acquire a fund that held that stock, or another stock with similar characteristics, in the same industry, etc.
Finally, you could employ both strategies. That is, after disposing of an investment at a loss, you could immediately acquire a similar investment to make sure you don’t miss any significant upside, and then after 31 days or more have passed, you can again acquire the original investment. Keep in mind that you may incur some additional trading costs by doing so, but if you felt strongly enough about re-acquiring the original investment, the additional costs may be justified.
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.
If you have any questions about your investment portfolio or your financial plan, or would like to have a discussion with a Portfolio Manager or Certified Financial Planner, just contact us.