Tax-loss selling is about deliberately selling "losing" investments to realize capital losses in taxable accounts.
CIBC Investor’s EdgeDec. 06, 2023
Tax-loss selling can be one of the most important year-end tax activities for investors with non-registered, taxable accounts. Tax-loss selling is about deliberately selling "losing" investments to realize capital losses. These losses can be used to offset capital gains that have been realized on "winning" investments, reducing capital gains tax payable. Any net capital losses that cannot be used in the current year may be carried back three years or carried forward indefinitely to offset net capital gains in future years. This approach may involve a shift in mindset for investors, to recognize that losses can provide some value for the portfolio.
How much value? Research from Vanguard US estimates that the median benefit of tax-loss selling was 0.45% during average levels of volatility and 0.95% during high levels of volatility. Let’s explain: the median benefit is based on the difference in the internal rate of return for portfolios with and without tax-loss selling, while the internal rate of return is roughly equivalent to annualized return. The benefit of tax-loss selling can add up over time, due to the power of compound interest.
To visualize the potential benefit of tax-loss selling for your portfolio, take your non-registered portfolio balance and apply a projected annualized return with and without tax-loss selling over a period of 10-20 years. The difference might surprise you! The benefit of tax-loss selling may be more pronounced for investors with very large investment portfolios, where investors typically have a significant level of taxable capital gains
The starting point for tax-loss selling is to calculate the capital gains or losses on each investment. Investors can do this in three steps, going from a coarse to a fine level of detail.
The first step is price change. This will give a rough sense of which securities could be candidates for tax-loss selling. Here it might be useful to establish a minimum capital loss to justify the time and effort involved in tax-loss selling. Consider setting this not as a percentage loss for each security but as a minimum dollar value. For example, a 25% loss on a $1,000 investment is $250, but a 5% loss on a $100,000 investment is $5,000.
The second step involves calculating the adjusted cost base (ACB) of the investment. Recall that a capital gain or loss is equal to the sale price of the investment, less the ACB and the expenses incurred to sell the investment. ACB can be affected by a number of factors, including where an investor:
Held identical securities in more than one non-registered account.
Had previously realized losses that were subject to the superficial loss rules outlined below.
Transferred securities into their account but did not previously provide us with the correct ACB of each security.
Undertook certain "rollover" transactions, including spousal or estate and trust rollovers.
Held securities in which certain corporate actions such as mergers and spin-offs were reported as taxable dispositions or distributions.
Sold units of an income trust, REIT, ETF or mutual fund and the ACB was adjusted to reflect return of capital or phantom distributions.
Held Canadian Depositary Receipts.
Sold securities short.
As a result of these and other issues, brokerage statements do not provide the adjusted cost base for investments. For further details, see T5008 / Relevé 18 Statement of Securities, Frequently Asked Questions (PDF, 115 KB) Opens in a new window.. Investors may need to consult a tax advisor to determine their adjusted cost base.
The third step involves foreign securities. Both your ACB and proceeds of disposition that you use to calculate your capital gain or loss must be converted to Canadian dollars. Assume you buy 1,000 shares of XYZ Corporation at USD 100 per share for a position of USD 100,000, when the USD and CAD are at par. Later, the stock price has fallen to USD 90 and the position to USD 90,000, so it looks like you have a 10% loss to claim. Whether this is true depends on the value in Canadian dollars. Say the US dollar has gained 20% against the Canadian dollar, where USD 1.00 equals CAD 1.20. In this case, the position of USD 90,000 is worth CAD 108,000. Instead of a capital loss of $10,000 in USD, you have a capital gain of $8,000 in CAD.
Foreign exchange rates are available from the Bank of CanadaOpens in a new window.. These rates are accepted by Canada Revenue Agency for tax reporting. For tax-loss selling, your accountant or tax advisor will likely need the exchange rate for the specific day of purchase and sale, not just an average exchange rate for the month.
The superficial loss rule
We've outlined a process for tax-loss selling that starts with price change and proceeds with increasingly detailed steps relating to ACB and foreign securities. Assuming an investor has identified some candidate securities to sell, they now have to be careful about the 30-day rule, or superficial loss rule. If an investor sells an investment for a loss, this rule denies the loss and adds the loss to the ACB of the repurchased investment if the investor or an "affiliated person" buys the same or an identical investment within 30 calendar days of the sale and continues to hold the investment 30 days after the sale. Let's take a closer look at some of the key definitions in the rule.
The 30 days is actually 61 days for the purchase period, since the Income Tax Act defines the purchase period as one "that begins 30 days before and ends 30 days after the disposition".
"Affiliated person" includes your spouse or partner, a corporation controlled by you or your spouse or partner, or a trust of which you or your spouse or partner are a majority beneficiary, such as your RRSP or TFSA. To be extra clear, the rule applies across accounts. For example, if you sell a security for a loss in your non-registered account and your spouse buys the same security 25 days later in their RRSP, you would be offside under the 30-day rule, even if you did not buy the security in your own non-registered account.
What constitutes an identical investment for the superficial loss rules is a factual determination. For example, if an investor were to sell a Russell 3000 equity ETF at a loss, they cannot buy the same fund within 30 days of sale, if they want to claim the loss for tax purposes in the year of disposition. However, an alternative US equity ETF, such as one based on a total market index, could provide similar equity exposure, and would likely not be considered identical. By carefully applying the definition of a identical investment, investors can potentially benefit from claiming a tax loss, while maintaining similar but not identical exposure within 30 days of sale.
The last part of the tax-loss selling process is timing the trade, which has to settle by year-end. As of 2023, most securities in Canada and the United States settle two days after the trade date, known as T plus 2. This is due to change to T plus 1 on May 28, 2024. Suffice to say that investors should leave enough time for their trades to settle by year-end, taking account of holidays in Canada and the United States. Happy tax-loss selling!