Tax Loss Harvesting

Tax loss harvesting (sometimes referred to as tax loss selling) is a simple but powerful way to reduce paying taxes for investors who hold investments in non-registered accounts. While it would be nice to only buy investments that go up in value, the reality is that investments have cycles, and some investments lead to losses. But tax loss harvesting can allow you to convert losses into tax-saving opportunities. You can harvest losses by selling securities and use those capital losses to offset capital gains. Even better, you might be able to offset capital gains received in the past and carry forward capital losses to offset future gains. In the end, this means paying less tax, which could lead to more money on your balance sheet at the end of the day. In this article, we'll explain how tax loss harvesting works and some of the finer points about the strategy you need to be aware of to use it correctly.

What is tax loss harvesting?

Let's first discuss capital gains. A capital gain is when you hold an investment worth more than what you bought it for. For example, you purchased $10,000 worth of Stock ABC. A year later, it is now worth $15,000. That means you would be a capital gain of $5,000. If you still hold the stock, the gain is 'unrealized.' If you were to sell all $15,000 worth of the stock, you would have a 'realized' capital gain. Realized capital gains are subject to tax in non-registered accounts. (In other words, if this investment was in your RRSP or TFSA, you wouldn't have to worry about paying tax on the capital gains while the investments and money remain inside those tax-preferred accounts. That's part of why these types of accounts are referred to as tax-preferred accounts). In non-registered accounts, when you have a realized capital gain, you pay income tax on that gain in the tax year you realized the capital gain. In Canada, realized capital gains have an 'inclusion rate' of 50%, and that 50% (known as your 'taxable capital gains') is then taxed at your marginal tax rate. Continuing from our example of a $5,000 realized capital gain, at a 50% capital gains inclusion rate, we have $2,500 of a taxable capital gain that would be subject to income tax. If your marginal income tax rate was 45%, you would owe 45% x $2,500 or $1,125 in income tax.

Capital losses are the inverse of capital gains. If we originally bought $10,000 worth of another stock, let's say Stock XYZ, it's now worth $5,000. We have an unrealized capital loss of $5,000. And this is where tax loss harvesting can come into play. If we sold Stock XZY for $5,000, we would then 'realize' that capital loss. According to the tax rules in Canada, we could use these capital losses to offset realized capital gains. In our case, we could take the $5,000 of realized capital losses on Stock XYZ and fully offset the $5,000 realized capital gain of Stock ABC. The result is that we no longer have a net capital gain to pay tax on. By tax loss harvesting, in this case, by realizing the capital loss on Stock XYZ, we could reduce our tax owing by $1,125.

How does tax loss harvesting work?

Whenever markets or individual securities have been performing poorly, there can be opportunities to harvest capital losses to offset capital gains. You can harvest tax losses any time during the year, but you'll often see reminders about tax loss harvesting in December if you want to harvest losses before the tax year closes.

It's important to note that even though you might not have any taxable capital gains in one particular year, you could still benefit from harvesting capital losses. That is because if you don't have enough (or any) realized capital gains in the year you harvest capital losses, you can go back three tax years and offset capital gains from those prior years or apply them in future tax years. (If you want to apply them to previous years, you need to file a T1A form with the Canada Revenue Agency.)

Things to consider when tax loss harvesting

If you've bought securities knowing that the values could fluctuate in the short term with the expectation of higher potential long-term returns, you may wonder if selling securities at a loss could be a bad idea, especially if the security turns around and then starts performing well. And you might think, 'No problem, I'll just sell to realize the loss and then buy it right back so I can participate in any future upside price movement.' This situation could be a problem when it comes to your ability to claim those losses. It has to do with what's known as a 'superficial loss.'

Superficial losses and tax loss harvesting

If a realized capital loss is deemed a superficial loss, then you will not be able to claim the realized capital loss against realized capital gains. A superficial loss is when you, or someone affiliated with you, buys the same property within 30 calendar days before or after the day you sold your shares and continues to hold it at the end of the 30 calendar days after you sold your shares. The general takeaway from this is that you can't just sell shares at a loss, buy them right back the next day, and expect to be able to claim the harvested capital losses against realized capital gains.

Avoiding the superficial loss rules and still re-investing after tax loss harvesting

There are a few workarounds that are available to investors who are looking for a way to harvest tax losses while still being exposed to securities that are similar to the security sold. The rules specify that you can't buy the 'same' or 'identical' security, but you can buy 'similar' securities. For example, let's say you owned an index  ETF   that tracked the S&P/TSX Standard and Poor's 500/Toronto Stock Exchange Composite Index and sold it to harvest capital losses. You could immediately buy another index ETF that tracked another Canadian broad stock market index as long as it was tracking a different index — and not the exact same one. Doing this would help you avoid the superficial loss rule.

Your options are slightly limited if you are tax loss harvesting from individual stocks. But if you were tax loss harvesting shares of one of the big Canadian banks, you could purchase shares of one of the other big Canadian banks to avoid the superficial loss rule. While the performance of the different companies and their stocks could, in theory, be quite different, they are both big bank stocks and have shared some general risk and return metrics historically. So, you would maintain exposure to the Canadian banking sector using this strategy.

And, of course, another option is to wait until the 30-calendar day period has elapsed before buying back the same security. The risk here is that during those 30 days, there will be a differential in performance between the security you sold and what you hold during those 30 days, be it cash or another security.

Don’t wait until the last trading day of the year

You may not want to wait until the year's final trading day to determine if you will engage in any tax-loss selling. Your trade has to settle before the end of the year. Depending on the type of security, the settlement date can be a few days after the trade date. Look at your accounts to identify losses that could be realized by the second or third week of December so that you can plan your trades accordingly to beat the year-end deadline.

Tax loss harvesting in Canada summarized

Tax loss harvesting is a relatively simple strategy that could save you tax if you invest in non-registered accounts. It allows you to harvest losses in a portfolio to claim taxable losses against taxable gains. You can apply these losses against realized capital gains in the current tax year, up to the three previous tax years, or carry them forward indefinitely to be used against future realized capital gains. It can lower the amount of tax you pay, which can increase the after-tax performance of your portfolio.

It's easy to see any unrealized losses in your account using  BMO B M O InvestorLine's 'holdings details' tab. Each security's unrealized losses or gains are reported in the table. You could use this to identify potential tax loss harvesting opportunities quickly. Even if you don't have any realized capital gains to offset right now, consider tax loss harvesting now and carrying forward those taxable losses to be used in future years.

There are specific rules to be aware of, such as the superficial loss rule, which can invalidate claiming realized losses against your realized gains. If you are unsure of how tax loss harvesting would work for you, make sure to consult with a qualified tax professional.