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You may have heard the term tax loss harvesting or tax loss selling. Did you know that it may help you significantly reduce your tax burden over a period of time? Read on to see how it may be possible to use tax loss harvesting to your advantage.
What is tax loss harvesting?
When you sell an investment within a non-registered account, such as a stock or a bond, for less than its adjusted cost base (ACB), it triggers a capital loss. The ACB is simply the purchase price (book value) of the investment, plus any acquisition costs, such as commissions or legal fees. A capital loss can be used to offset a capital gain within a non-registered account. This maneuver is known as tax-loss harvesting (or tax loss selling). It offers a tremendous amount of flexibility. You can use current capital losses to offset capital gains in the current tax year. You can also carry back capital losses three preceding years or carry them forward indefinitely. It can be a way for investors to minimize a tax liability after a sizeable gain.
How does tax loss harvesting works?
In Canada, you can apply capital losses against capital gains. This can help you lower or even nullify any taxes owed as a result of a capital gain by simply selling an investment that has an unrealized loss to offset the gain. This allows you to achieve a certain amount of tax savings.
While this article offers general guidance, it is not tax or investment advice. It is always in your best interest to work with a tax or investment professional who can offer personalized support.
Key factors to consider
- Superficial Loss: When employing tax-loss harvesting, make sure to consider the CRA's “superficial loss” rule. According to this rule, investors claiming a capital loss on the sale of an investment cannot buy the same investment within 30 days of the sale. For example, disposing of capital property for a loss, and repurchasing the same property within a 30-day period following its sale, the CRA's "superficial loss" rule will come into effect. This means a capital loss cannot be deducted from your income for the year. The "superficial loss" 30-day rule is specifically designed to prevent investors from playing the system to lower their income tax payments.
- Portfolio Rebalancing: Tax-loss harvesting can be used to rebalance a portfolio. Remember to pay special attention to the cost basis – the adjusted, original purchase value. This will help determine the capital losses or gains on each asset.
- Inclusion Rate: This can help calculate the taxable capital gain or allowable capital loss for the year. For 2021, the inclusion rate is 50%. You simply multiply capital gain or capital loss for the year by this rate to help determine the tax burden on resulting capital gains. The rate has fluctuated over the years. Due to this, the net capital losses of previous years are dependent on the inclusion rate that was in effect at the time.
- Your investment type: The nature of investments will impact how easy or difficult tax-loss harvesting is. For a portfolio that consists of individual stocks or exchange-traded funds (ETFs), tax-loss harvesting can be easier to employ. Investing only in mutual funds can be more challenging as mutual funds sometimes make annual capital gains distributions regardless of whether investors continue to hold the fund units or not. This annual capital gains distribution forces investors to pay Canadian capital gains tax on 50% of the sum.
- Long-term strategy: Consider effective tax planning to determine the impact to your investment decisions. Attributes of different securities (like asset allocation, future outlook, overall investing strategy and financial goals) can help you to decide whether to hold or to sell.
- Eligibility: Tax loss harvesting only applies to investments sold in non-registered accounts. Capital gains inside registered accounts, such as an RRSP or TFSA, are tax exempt. The CRA does not allow the use of capital losses within registered accounts to offset gains in other accounts.
- Year-end deadline: To offset gains realized in a calendar year, losses must be settled within that same year. For example, a capital gain of $2000 realized in March, and a loss position of $2000 in a certain stock realized in May of the same year, can help to offset gains and losses for the year.
On a final note
Tax-loss harvesting is a powerful tool that can help reduce a person's overall tax burden. While tax-loss harvesting may not restore an investor to their previous position, it can lessen the severity of the loss if the strategy is applied correctly and in appropriate situations. Being proactive and understanding the options available ahead of time can help you identify the best strategy to support your needs.
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