Tax loss harvesting

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Financial Planning
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Tax planning

Tax loss harvesting, also known as tax loss selling, is the practice of selling shares (or units), held in a non-registered account, that have dropped in value to the point that a capital loss can be claimed (e.g., [1][2]). The capital loss can be used to offset capital gains, either in the current year or in the previous three tax years, or they can be carried forward to any future year.[3]

Tax loss harvesting tends to happen near the end of the year, although there is no specific requirement. Note that the loss must be calculated in Canadian dollars: when using securities traded in other currencies, such as US dollars, make you you actually have a loss in CAD, relative to your adjusted cost base in CAD, before you pull the trigger.[2]

Timing and settlement

Main articles: Settlement date and Tax planning

If you are tax loss harvesting near the end of the year, you should be aware of settlement dates and final trade dates. Important dates for security settlement are:

  • Dec 27th, 2023 - final trade date for Canadian equities for settlement in 2023 tax year[4]
  • Dec 27th, 2023 - final trade date for US equities for settlement in 2023 tax year.[4]
  • Dec 28th, 2023 - final trade date for Options for settlement in 2023 tax year.

You should also check with your discount broker because some markets close early around holidays.

Superficial loss rules

Main article: Superficial loss

Canada Revenue Agency (CRA) rules specify that you or an affiliated person cannot buy back the security again within thirty (30) days or you will run afoul of CRA's superficial loss rules and the tax loss will be denied.[5]

Transferring losses to your spouse

It is possible to use the superficial loss rules to transfer capital losses from one spouse to another to reduce their capital gains.[6] This involves one spouse (Jack) selling a security at a capital loss and having the other spouse (Jill) purchase the same security within 30 days. Superficial loss rules will deny Jack the capital loss, but Jill's adjusted cost base is increased by the amount of the capital loss. As long as Jill doesn't sell the security within 30 days from the original transaction, the capital loss has effectively been transferred between spouses. It is important to note that the specific timing of the transactions matters here.

Replacing the sold security

To keep your asset allocation constant despite the tax loss harvesting, you can repurchase a very similar, but not identical, security immediately.[1] For example, you can sell your shares in Canadian bank A and purchase shares in Canadian bank B with the proceeds. Or you can sell shares of an exchange-traded fund (ETF) covering Canadian equities and buy another ETF based on a slightly different index (see external links below for more details).

After the 30 day waiting period required to avoid a superficial loss, you can sell the replacement security and repurchase the original one. However, this will involve trading costs, and may generate taxable capital gains (depending on what has happened to the price of the replacement security during the waiting period). Therefore, if the replacement security is a very close equivalent to the original one -- especially in the case of ETF pairs --, there might be no reason to switch back.

Thresholds

Tax loss selling implies costs, in the form of commissions and bid-ask spreads. During times of high market volatility, the market can move against you during the few seconds or tens of seconds it takes to perform the switch. There is also additional book-keeping involved. Therefore, investors might want to decide on minimum thresholds above which they will engage in tax loss harvesting. These thresholds can be included in one's Investment Policy Statement for future reference.

Permanent replacement

For example, for a permanent replacement, Larry Swedroe recommends that the original security must show a minimum decline of $5000 and 5% relative to the adjusted cost base.[7] The percentage loss was included in the rule because total bid-ask spread costs depend on the number of shares involved (or total security value). Other examples of rules are:

  • $1000 and 2.5%[8]
  • $1000 and 3%[9]

DIY investors might adopt different personalized thresholds, as a function of their specific trading costs, tax rates, minimum acceptable tax savings, etc.

Temporary switch

The tax loss harvesting criteria should be more stringent if there is an intent to switch back to the original security after the end of the 30 day holding period, for example a minimum threshold of $10,000 and 10%.[10] This is because more trading costs are involved in making a round-trip, and the replacement security might rise in price during the waiting period, partly or totally cancelling the loss that was triggered by selling the original security.

Does it work?

Most academic studies about tax loss selling come from the US, where the tax rules are different. Such US studies show a potential "tax alpha" (extra return) of about 1% per year, using several assumptions.[11] For the Chaudhuri et al. (2020) study, these assumptions include:

  1. the portfolio consists of individual stocks, creating abundant winners and losers (unlike a portfolio of mutual funds or ETFs, where there are fewer loss harvesting opportunities);
  2. capital gains are always immediately available, to use the harvested losses, so that tax credits can be treated as cash infusions into the portfolio;
  3. there are no transactions costs (like commissions and bid-ask spreads);
  4. the "wash sale rule" (the US equivalent to the superficial loss rule) does not apply;
  5. tax rates are constant over time, but different for short term gains versus long term gains (this is a US rule).

In the real world, many of these assumptions will not apply. Also, in Canada, the way the cost base is calculated differs (there is no HIFO accounting), and there is no difference between short-term and long-term gains. In short, these US studies probably overstate the potential benefits of tax loss harvesting, especially for Canadian investors.[12]

Tax loss harvesting is a tax deferral strategy: the tax does not magically go away. You are saving tax immediately (by applying the losses to this year to cancel capital gains, or to previous years in which you had gains), or over the next few years (by applying a net loss to future gains). But the replacement security has a lower ACB than the original one, which means there will be more taxes to pay in the future than would otherwise be the case, if tax loss selling had not be performed. If the future tax rate of the investor is the same or lower than the current one, the tax deferral should be beneficial. But if future tax rates are higher, not so much.[12]

In the absence of varying tax rates, it makes sense to use the harvested losses as soon as possible:[13]

Although capital losses can be carried forward indefinitely – i.e., to be applied against future capital gains – the further into the future your capital gain is, the lower the "present value" of your capital loss carryforward.

See also

References

  1. ^ a b John Heinzl, How to effectively use tax-loss selling to lower your tax bill, The Globe and Mail, November 17, 2017, viewed February 12, 2018
  2. ^ a b Jamie Golombek, Here's how to make the most of tax-loss-selling season, National Post, November 22, 2019
  3. ^ Canada Revenue Agency (CRA), How do you use a capital loss?, viewed February 10, 2014.
  4. ^ a b "Tax treatment of investments - trade and settlement dates; Last trading date for 2023". TaxTips.ca. November 27, 2023. Retrieved November 28, 2023.
  5. ^ Income Tax Act, Taxable Capital Gains and Allowable Capital Losses, section 54, viewed February 1, 2020.
  6. ^ How your loss can be your spouse's gain - The Globe and Mail, viewed December 16, 2014.
  7. ^ "The Only Guide You'll Ever Need for the Right Financial Plan", a book by Larry Swedroe, quoted in D. Bortolotti & J. Bender, Tax Loss Selling Using Canadian-listed ETFs to defer taxes on capital gains, PWL Capital White Paper, October 2013
  8. ^ Financial Wisdom Forum, post by Quebec on December 5, 2019
  9. ^ Canadian Portfolio Manager, Part 3: Two Takes on Tax-Loss Selling: Justwealth vs. PWL, December 16, 2019, viewed January 11, 2020
  10. ^ Justin Bender, Podcast 2: Dumping Your Losers – Tax-Loss Selling With ETFs, "Justin Bender’s $10,000 and 10% adjusted rule", at the 16 minutes mark, November 27 2019, listened to on December 5, 2019
  11. ^ Chaudhuri S, Burnham T, Lo AW (2020) An Empirical Evaluation of Tax-Loss Harvesting Alpha, Financial Analysts Journal, v. 76, p. 99-108, available on SSRS, viewed April 11, 2022.
  12. ^ a b Rational Reminder Podcast, episode 158, Loss Harvesting and the Myth of Tax Alpha, July 15, 2021, viewed April 10, 2022.
  13. ^ Samantha Prasad (Minden Gross LLP), Line Up Your Losses Now, December 6, 2021, viewed April 11, 2022.

Further reading

External links

General advice

Tax loss harvesting with ETFs

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