Tax-loss selling – building a better understanding

This time of year marks a shift into holiday mode for many individuals and families, often embracing the joys and spirit of the season, whether that means traditional celebrations, get-togethers, travel or otherwise. At the other end of the spectrum (and understandably not as joyous to think about as the holidays), year-end also represents a very important time for tax planning. Among many investors, two of the biggest challenges related to tax are minimizing taxable gains and finding ways to effectively manage losses. It’s here where the technique of tax-loss selling may be advantageous on both accounts. At the highest level, tax-loss selling is a method of selling investment assets that have decreased in value to create a loss, which can then be used to offset capital gains in other areas. Despite its potential upsides, the overall concept of selling at a loss often generates feelings of uncertainty among many individuals because it demands a fundamental shift in mindset away from the age-old notion of “Buy low, sell high,” and it introduces change to the process in a way the investor may not have anticipated. Before ruling it out as an option, however, it’s worthwhile to understand if, when and how tax-loss selling may offer benefits as part of your overall tax-planning strategy.

How it works

When looking at the concept of investing, the basic process involves setting shorter- and longer-term goals, identifying risk tolerance and making decisions based on those factors to ultimately generate gains. Taking it one step further, a crucial part of the process also includes managing those gains and the related tax outcomes, because the reality is that taxes are a real consequence of investing. This in itself highlights the importance of integrating strategies to more effectively deal with the consequences, and that’s where techniques like tax-loss selling come into play. While this article addresses some specific considerations and aspects of tax-loss selling, it is just one of many options and approaches to take into account. For a complete overview of year-end tax planning, as well as more key details about this particular technique, please view “A tax perspective on year-end”.

In Canada, the income inclusion rate for capital gains is 50 percent, which then gets taxed at an individual’s marginal tax rate. What that means is on a capital gain of $20,000, for example, $10,000 would become taxable income. If that investor was in a 35 percent tax bracket, the taxes owing on the gain would therefore be $3,500. With tax-loss selling, investors are able to sell non-registered assets and investments that have dropped in value (this strategy does not apply to assets held within registered investments such as RRSPs or TFSAs), generating a loss that can then help decrease their tax bill.

Considerations and limitations

There are a range of factors that need to be addressed before deciding to employ this strategy. If a specific non-registered asset or investment has decreased in value, one of the first things individuals and their wealth and investment advisors need to discuss is whether it still fits with their overall investment objectives and if its risk attributes remain within their tolerance level. In other words, overall investment values and goals should always take priority over potential tax advantages. If the shares are not likely to rebound soon, the tax advantage may be a worthwhile strategy to consider. The next questions that need to be asked are as follows:

1. Do I have any crystallized (triggered or realized) gains that need to be offset this year? If so, these are the ones that the sale of a loss would offset first.
2. Have I realized any capital gains in the last three years? This technique allows current-year unused losses to be applied back three years.
3. Do I have unused losses from previous years? Since unused losses may be carried forward indefinitely, it may be more advantageous to use those before harvesting new losses.

Note: To ensure your specific circumstances have been properly evaluated in addressing these questions, it is important to consult with a professional tax advisor.

The main limitation from a tax-laws standpoint individuals need to be aware of with tax-loss selling is what’s termed “superficial loss.” These rules look at the period of 30 days before and after the sale date, and will deny an individual’s ability to claim a loss if they sell at a loss and then they or an affiliated individual (which is defined as your spouse, a company controlled by you and/or your spouse, or a trust in which you and/or your spouse are a majority interest beneficiary) repurchases the same investment in that 61-day window (which includes the sale date) and continues to hold the repurchased investment on the 30th day following the sale. If this occurs, the loss then doesn’t qualify to offset gains for the year and is instead added to the adjusted cost base of the repurchased asset. It’s also worthwhile to note that you can’t get around this rule by repurchasing the same asset in a different account, like an RRSP or TFSA, within the 30 days before or after the sale date or the loss is permanently denied. For those who still want to have some sort of exposure to that type of asset or are fearful about eliminating an investment they have a conviction with, purchasing a similar product is possible. In considering this option, however, it’s important to speak to your advisor to ensure it still suits your investment objectives; keep in mind that investment rationale should always be assessed, and this strategy may not be appropriate for all investors.

The 2016 official deadline for the sale of assets (trade date) in order to realize the losses is December 23, and while this calendar date naturally insinuates that it’s a year-end strategy, that’s not to say it’s the only time. Opportunities for selling at a loss should be considered throughout the year. In general, many investors begin to look at this strategy in the fall, but while it can be done over a couple of months, the best opportunities may not always come at the end of the year, depending on individual circumstances. With that in mind, it’s good practice to review your portfolio with your wealth and investment advisor on a quarterly basis over the course of the year.

Another key aspect to highlight is that this doesn’t have to — and often shouldn’t — be a one-time strategy to offset gains in a particular year. Some individuals may be more inclined to consider this technique in situations or years where gains may be higher than usual or when an event has occurred that triggers a large capital gain (such as the sale of a vacation property, for example). But in the big picture, tax-loss selling may play an important role year after year as part of the overall, long-term approach.

When emotions come into play

Without a doubt, there’s an influential psychological and emotional element tied to investing, and it’s something that is natural and expected when financial well-being and long-term goals rely on those investments. It’s factors such as these that often make it difficult for many to accept a concept that requires taking a loss. Recognizing that a loss can sometimes be advantageous therefore requires a shift in the more traditional framework of thinking around investing. Oftentimes, human nature and fears of losing out tend to creep in and create a level of unwillingness among some individuals to sell — and this occurs both at a gain or at a loss. It’s important to recognize, however, that selling — on both fronts — is an integral part of investing, because it generates a return while also protecting capital via a phased approach over time. Specifically in regards to losses, when strategized in the right way at the right time, they may also help to reduce the concentrated risk individuals are taking on.

When it comes to investing, there’s an element of give and take that must be present in order to maintain balance over time as market conditions, personal situations or goals change. Part of what makes that give and take successful is an awareness of and an open mindset towards the full scope of options and strategies available. Depending on individual circumstances and time horizon, investments may sometimes require adjustments and rebalancing along the way. While it won’t always be 100 percent, there are approaches available to help manage risk in the most tax-efficient ways possible, and this is a situation where it’s imperative to consult with a qualified advisor to determine the best options for individual needs.