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ETF Tax-Loss Harvesting

Using exchange-traded funds in tax-loss planning

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Canadian investors are increasing their exposure to exchange-traded funds (ETFs). These funds can help unlock many compelling investment opportunities and can also be used to reach a variety of other financial goals. In this article, we’ll explore the use of ETFs in tax-loss harvesting – also referred to as tax loss selling.

What is tax-loss harvesting?

Investors can use tax-loss harvesting by selling non-registered investments for a value below their original cost. The idea is to crystallize capital losses to offset any capital gains realized in that tax year. It’s also possible to carry capital losses back into the previous three tax years and/or carry them forward indefinitely.

Meanwhile, investors can purchase similar assets to the ones just sold. This makes it possible to remain in the market and maintain a well-balanced portfolio. However, keep in mind the “superficial loss” rule. This rule states that if investors buy back the same security within 30 days of the sale, they cannot claim the tax benefit from the capital loss.

Using ETFs in a tax-loss strategy

At first glance, the superficial loss rule appears to limit the options available to investors. However, there is a way to buy back into the same asset class or sector using ETFs.

For example, let’s say you sell shares of a Canadian bank at a loss. Two weeks later, you see indicators that the Canadian banking industry may be poised to regain some ground. Of course, you cannot repurchase shares of the same bank within 30 days without invalidating your capital loss. But you can buy a Canadian bank stock ETF instead. The ETF is considered “materially different” from your original position, so it does not trigger the superficial loss rule. It’s a convenient, low-cost and transparent way to gain exposure to a given asset class or sector after selling a security at a loss.

Of course, this solution will not provide the exact exposure of your original position, but it does enable you to participate in the potential rebound of stocks in the Canadian banking sector. And single stocks can have high correlations to sectors in many cases. This is especially true in banking.

Another advantage: Greater flexibility and diversification potential

All ETFs have the advantage of providing easy re-entry to a given market. Just keep in mind the following when using ETFs in tax-loss harvesting:

  • A tax loss may provide the opportunity to make a portfolio adjustment.
    The security sold can be effectively replaced with an ETF that can help meet specific investment goals, such as market exposure, portfolio diversification or volatility management.
  • You can still apply this strategy when the assets sold at a loss are shares or units of another ETF (or mutual fund).
    Reinvesting in a different ETF can be a way of upgrading or repositioning that investment. However, if you sell shares of an ETF and buy back into another ETF that tracks the same index within 30 days, you may likely trigger the superficial loss rule.

Remember: when it comes to tax strategies, one size does not fit all. No set of guidelines applies to every investor. So, when considering a tax-loss harvesting strategy, always:

  • Consult with a tax specialist before planning or enacting a tax-loss strategy.
  • Closely watch end-of-year deadlines for completing a tax-loss sale. To apply the loss to the current tax year, you must ensure that the transaction settles by December 31. Remember, settlement dates are typically two business days after a sale is initiated.

For more information on ETFs and tax efficiency, please contact your RBC advisor.

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