Tax loss selling (or “harvesting losses”) enables investors to benefit from any investments they hold outside of tax-sheltered plans like Registered Retirement Savings Plans and Tax-Free Savings Accounts that have dropped in value, in order to generate a tax loss that will decrease their current, previous or future tax bills.
Why is it a year-end tax strategy?
This year-end tax planning happens when it does for the simple fact that taxation authorities like the Canada Revenue Agency (CRA) and U.S. Internal Revenue Service (IRS) use December 31st as the year end for tax purposes. Investors are also likely to have a better sense of how their investments might perform for the full calendar year closer to year end.
Realized versus unrealized
Realized gains and losses are those that have been earned, or crystallized, by selling the individual investments, to lock them in. Unrealized gains and losses are often referred to as paper gains or losses because they aren’t actual or earned gains until the position has been sold.
Realizing a gain or loss is what triggers tax consequences for the seller, and while the result of tax loss selling will always be the same – generating an eligible loss for tax purposes – how the losses are used will vary depending on each investor’s tax circumstances.
Loss carrybacks and carryforwards
Realized losses can be used to offset gains made in the same year, but also against gains realized during the previous three years. They can also be carried forward indefinitely, to offset future gains. The losses do not need to be used in their entirety in the same manner, so investors could conceivably offset some current year gains and carry some back and/or forward.
Note that in the U.S., losses cannot be carried back, and while there is no limit on the amount that can be harvested, at the time of publication the annual limit for claimable losses was US$3,000.
Beware superficial losses
Tax loss selling requires investors to remain out of any investment on which they crystallized a loss or an “identical” one (according to CRA), for at least 30 days, or else it will be deemed a superficial loss and ineligible for offsetting any gains.
The CRA actually interprets the rule to mean 30 days prior to the date of sale and 30 days post-sale, for a total of 61 days, as the trade date is considered separate.
Investors often want to park that money somewhere other than cash during the waiting period, but for tax purposes, it cannot be the same (or what tax authorities deem to be “identical”). Should the CRA wish to take a closer look, investors must be able to prove it’s an eligible capital loss.
The U.S., for its part, has what’s called the wash-sale rule, which requires investors to stay out of the investment for 60 days.
If the investment is reacquired too soon or an identical one is acquired, then the CRA requires the loss amount be added to the adjusted cost base (ACB) of the position in that investment.
Pooled funds and tax loss selling
Pooled investment vehicles like mutual funds and exchange-traded funds (ETFs) distribute income to unitholders on a pro rata basis, by way of distributions. They are taxable in the hands of the investor, unless held in a tax-sheltered account, and paid to investors who were unitholders on the date of record.
Capital gains distributions for many pooled vehicles are made towards the end of each calendar year. For this reason, those who invest later in the year (after all or most of the gains have been made) could get stuck with more than their fair share of the taxes owing on those capital gains. This is why investors should be careful about piling into successful investments later in the year.
Given that tax loss selling is a strategy that will be pursued by many investors around the same time, there could be many sellers in December, which would push prices even lower.
Investors wishing to pursue this strategy will have to consider how much of a loss they’re willing to take and perhaps abandon their plans or modify them, if prices start to slip too much for comfort.
While tax loss selling isn’t an overly complicated concept, it is always a good idea to consult an expert before engaging in activities that may affect anyone’s taxes.