Tax-loss harvesting, also referred to as tax-loss selling, can be used by investors with non-registered investments (stocks, bonds, mutual funds and ETFs) that are trading below their original cost. These investments can be sold, and the subsequent capital loss can be used to offset any capital gains incurred that tax year. It’s also possible to carry capital losses back into the previous three tax years and/or carry them forward indefinitely.
One consideration for investors when employing tax-loss harvesting is the “superficial loss” rule. This rule states that if an investor buys back the same security within 30 days of sale, the tax benefit from the capital loss will be nullified. At first glance, the superficial loss rule appears to limit the options for investors. For example, an investor who sells shares of a Canadian bank at a loss later sees indicators that the Canadian banking industry may be poised to regain some ground. However, the investor cannot repurchase shares of the same bank within 30 days without invalidating the sale as a capital loss.
There are, however, tax-loss harvesting strategies that allow you to maintain exposure to a particular stock or sector while still realizing a capital loss.
Going back to our example, after the investor sells their bank shares at a loss, they could then purchase a Canadian bank stock ETF or a Canadian equity mutual fund with a large exposure to the Financials sector. The investor will gain the tax advantage of the capital loss from the sale of the bank stock and be able to retain exposure to the financial industry because the ETF or mutual fund is considered “materially different” from the original position. While this solution will not provide the exact same exposure to the investor’s previous position, it enables the investor to participate in a potential rebound in the sector.
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More on superficial loss rules
When you sell and trigger a capital loss, you cannot deduct the loss if you purchase an identical security within 30 days of the settlement date of the transaction. This means you cannot purchase the security 30 days before or after your settlement date. In addition, you cannot own or have the right to acquire the identical security on the 30th day after the settlement date. Furthermore, “affiliates” cannot make the purchase.
The Canada Revenue Agency provides the following examples of affiliates:
- you and your spouse or common-law partner;
- you and a corporation that is controlled by you or your spouse or common-law partner;
- a partnership and a majority interest partner of the partnership; and
- 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.
What are identical securities?
Identical securities can be shares of the same company, units of the same ETF or mutual fund, or a competitor ETF or mutual fund that invests in the exact index that you just sold. To avoid breaching the superficial loss rules, investors must be careful not to purchase securities that offer identical exposure to the securities being sold. For example, investors could sell an individual equity or equity index ETF at a loss and purchase a rules-based equity ETF or dividend-paying mutual fund that covers the same region.
Important factors to keep in mind
When it comes to tax strategies, it is critical to remember that circumstances vary from individual to individual. While no set of guidelines applies to every investor, investors should keep the following in mind when considering a tax-loss harvesting strategy:
- Always consult with a tax specialist before planning or enacting a tax-loss strategy.
- Investors need to closely monitor end-of-year deadlines for completing a tax-loss sale to ensure that the transaction is finalized in time to apply to the current tax year (if that is desired). Remember, settlement dates are typically two business days after a sale is initiated.
When considering different tax strategies, talk to your advisor about the tax implications of selling or switching mutual funds.