Tax-Loss Selling

Tax-loss selling explained simply for clients

Tax-loss selling, also known as tax-loss harvesting, involves selling non-registered investments, such as mutual funds or exchange-traded funds (ETFs), that have declined in value below their purchase cost to realize a capital loss. This capital loss can be deducted from capital gains realized in the same tax year, reducing the amount of tax payable. In addition, capital losses can be used to offset gains realized in previous years or carried forward to reduce tax on future gains.

An example

When a client has $50,000 in capital gains earlier in the year and subsequently sells an investment at a $30,000 loss, the net taxable gain is reduced to $20,000.

This strategy does not apply to registered investments, such as those held in an RRSP or TFSA, since capital losses and gains realized in these accounts are not taxed.

Benefits of tax-loss selling There are several potential benefits to turning a capital loss into a tax win:

Potential for reducing the tax burden on investors

By offsetting capital gains with capital losses realized in the same tax year, investors can lower their taxable income and, in turn, their overall tax burden.

Capital losses can also be applied retroactively to offset gains realized in the previous three years or carried forward indefinitely to reduce tax on future gains.

It’s simple and flexible

Tax-loss selling does not require complex financial products or tax structures. It can reduce capital gains tax in the same tax year and free up cash for reinvestment opportunities.

Tax-loss selling can be used to optimize a portfolio

Selling at a loss can be used to rebalance a portfolio by liquidating underperforming investments and reallocating funds more effectively. This approach can help maintain market exposure, improve asset diversification and manage volatility.

It’s an easily available option

Any investor holding non-registered investments that have decreased in value can use this strategy to reduce capital gains taxes.

Best time to seize this opportunity The end of the tax year can be a good time to sell investments at a loss to offset capital gains realized during the year. However, it is essential to regularly review the investment portfolio to identify opportunities to sell at a loss.

Sometimes, investors may choose to realize a loss to:

• Transfer funds to other investment opportunities or adjust portfolio allocation
• Free up cash for personal expenses
• Dispose of an investment that is unlikely to regain its value

In fact, tax-loss selling can be especially effective in volatile markets, where capital losses are often more accessible than during bull markets.

Key tax rules to consider Tax-loss selling is subject to specific rules, including:

An investor who realizes a capital loss can first deduct it from capital gains in the same tax year to reduce taxable income. If no capital gains were realized that year or if losses exceed realized gains, these losses can be deducted from gains realized in the previous three tax years or carried forward indefinitely.

For a loss to be deductible in the current tax year, investment specialists must make sure that transactions carried out for the purpose of selling at a loss are completed no later than the second-to-last business day of the calendar year, since transactions are settled one business day after they are completed.

The Income Tax Act limits the amount of the loss realized and retained as a deductible capital loss to 50%

Capital gains and losses on foreign currency securities are calculated in Canadian dollars. For tax purposes, the exchange rate at the time of purchase is used to determine the cost base, while the exchange rate at the time of sale is used to determine the proceeds of disposition. Therefore, any change in the exchange rate during the holding period of the security directly influences the calculation of the capital gain or loss.

The Act also sets out the “superficial loss" rule, also known as the "30-day rule." This rule prevents an investor or an affiliated person 2 from deducting a capital loss realized on the sale of a security when the “same security” or an “identical security” is redeemed within 30 days before or after its sale, for a total of 61 days including the settlement date. After this period, the investor can repurchase the same securities without cancelling the capital loss. If the "superficial loss" rule is not met, the capital loss will not be deductible.

Why ETFs can be a great option Thanks to their flexibility, diversification potential and ease of trading, ETFs can be valuable instruments for carrying out tax-loss selling strategies. Selling underperforming ETFs allows investors to quickly realize capital losses to offset capital gains.

It is possible to sell an ETF at a loss and reinvest the funds in other ETFs of the same asset class or sector to maintain comparable exposure. However, these transactions must meet certain criteria to not be considered identical to the initial ETF sold at a loss.

For the capital loss to be recognized, the repurchased security must not be identical in its essential characteristics to the one sold. It must be considered "materially different", which implies notable distinctions. For example, an ETF in the same asset class (such as Canadian equities) but with a different benchmark or investment mandate (e.g., growth or dividend income) could offer exposure to similar securities and would likely not be considered identical.