Do you have investments that dropped in value this year?
Although somewhat counterintuitive, now might be the right time to sell them to capitalize on a tax-savings strategy commonly known as tax-loss harvesting.
As the deadline for tax-loss harvesting approaches, here are some of the intricate nuances and rules that experts say you should consider.
What is tax-loss harvesting?
Tax-loss harvesting, or tax-loss selling, involves deliberately selling an investment at a loss to offset your other investment gains. This helps reduce, or eliminate, the taxes you owe on your investment returns, which means more money in your pocket.
“So, it’s a way of turning a loss into a win to some degree,” Jason Pereira, senior financial planner at Woodgate Financial and president of the Financial Planning Association of Canada, said in an interview with Yahoo Finance Canada.
This strategy can be used for any investments subject to capital gains tax, which may include stocks, bonds, exchange-traded funds (ETFs), mutual funds, and even rental properties or cottages. Primary residences do not apply, nor do investments held within registered accounts like a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA), as those gains are already sheltered from taxes.
“Frankly, you eat the losses in registered accounts,” Pereira said.
Investors should also note that tax-loss harvesting works only when capital losses are realized. Since trades generally settle two business days after the transaction date, the last day to sell an asset for a loss this tax year is December 27.
Carrying your losses backward or forward
When triggered, capital losses are first applied against any capital gains from the same year. But if there are excess losses, they can be carried back to offset gains from the previous three years, or carried forward indefinitely to offset future gains.
Pereira says this tactic proved especially fruitful when the markets were down in 2022.
“We had clients getting $20,000 or $30,000 refunds,” he said. “They had previously paid capital gains tax in the last three years, and they were able to use the capital losses they had last year to get back that money as a cheque from the government.”
Similarly, investors triggering capital losses in 2023 can go back as far as 2020 to offset reported capital gains. And that’s where they should probably start, says Frank Di Pietro, assistant vice-president of tax and estate planning at Mackenzie Investments.
“You generally want to start with the oldest gains … because those ones are going to fall off the schedule first,” Di Pietro told Yahoo Finance Canada. “After this year, you won’t be able to recover taxes on those capital gains taxes that were paid [in 2020].”
Before triggering a loss for the sole purpose of lowering your tax bill, however, Di Pietro reminds investors that unused losses from previous years could potentially achieve the same result.
“This is all done in the current year tax filing,” he added.
Be aware of the superficial loss rule
Selling a losing investment contradicts the conventional wisdom of buying low and selling high. That’s why tax-loss harvesting typically involves a second step: getting back into the market.
But if you wish to repurchase the same asset you just sold, you’ll have to wait at least 30 days. Otherwise, it’s considered a superficial loss, and can’t be used to offset capital gains.
Unbeknownst to some, the superficial loss rule also covers the 30 days before a sale.
“So, it’s a 61-day window that you have to look at to see if there were any purchases by you or anyone affiliated with you, and whether you continue to own those investments at the end of that period,” Di Pietro explains, referencing a client whose loss was denied due to an automatic purchase made by their pre-authorized contribution plan.
Some examples of affiliated entities that cannot purchase the same asset during this window include your spouse or common-law partner and a corporation controlled by either of you. The property cannot be repurchased into your RRSPs or TFSAs, either.
Instead, investors can purchase a similar – but not identical – property at any time.
“The classic example is if someone sells Coke and then buys Pepsi,” Pereira said. “It doesn’t mean that Coke can’t outperform Pepsi in that period of time, but if anything affects the industry it’s probably going to affect them both.”
Is tax-loss selling right for you?
If you have capital gains to offset and aren’t optimistic about the prospects of an investment, or if it’s relatively stable, Pereira and Di Pietro agree tax-loss harvesting could prove beneficial.
But it's not necessarily for everyone.
In some cases, Pereira says tax-loss harvesting just defers the eventual taxation of a portfolio, which could make an investor worse off if they end up in a higher tax bracket. Other factors that may impact the effectiveness of the strategy include transaction costs and timing.
“If a portfolio takes a nosedive in February, that’s a time to do it too,” Pereira said.
Above all, Pereira and Di Pietro stress the importance of evaluating your unique financial situation and, ideally, consulting with a financial advisor before taking any action.
Farhan Devji is a freelance journalist and published author based in Vancouver. You can follow him on Twitter @farhandevji.