We get it. Some people love podcasts they can travel with during their daily commutes. Others of you prefer your learning accompanied by charts, graphs and handy hyperlinks.

At PWL, we aim to please all sorts! That’s why my new series on tax-loss selling comes in two flavors: a delicious podcast version, as well as this savory multi-part series of blog posts.

So, without further ado, let’s dive into the subject of tax-loss selling – a strategy investors can use to defer taxes on their taxable capital gains.

Making a Killing in the Market

Picture this. You’ve finally made the plunge into index investing. Things are going pretty well … until markets take a nosedive, as they periodically do.

You know you shouldn’t, but you can’t help yourself: You begin stalking your accounts with hourly logins, haunted by the red losses piling up like murder victims. You start to second-guess your entire strategy. Your anxiety is aided and abetted by the popular press, telling you the 60/40 stock/bond portfolio is dead, and suggesting that passive investing is the culprit.

All of this is nonsense, of course. The truth is, you’ve made a great decision to switch to low-cost index investing. Downturns happen. When they arrive on the scene, your best bet is to chill, until they pass.

However, holding tight doesn’t necessarily mean doing nothing. Taking a more active tax management approach can make sense for even the most passive indexing purists.

Winning by Losing

This is where tax-loss selling comes in handy. No one likes losing money on an investment. But sometimes, realizing capital losses can enhance your bottom line by reducing your tax bill while you patiently wait for markets to recover. Because you will be patient, right?

Tax-loss selling – also known as tax-loss harvesting – is a technique for realizing, or crystallizing, capital losses in your non-registered accounts so they can be used to offset taxable capital gains.

To be clear, there is no benefit to tax-loss selling in your TFSA or RRSP. This entire conversation only applies to your non-registered accounts, where deferring capital gains taxes can give your money more time to grow.

Tax-Loss Selling Made Crystal Clear

As an example, suppose you invest $100,000 in a Canadian equity ETF, and then the value declines to $90,000. By selling your shares, you can crystallize a capital loss of $10,000, and potentially use that loss to offset a $10,000 capital gain elsewhere in your portfolio. By deferring thousands of dollars in taxes, there’s more left in your portfolio to compound over time.

Tax-loss selling may sound like the cardinal sin of “selling low,” but we’ll explain in a moment why, when properly executed, that’s not the case.

Before engaging in tax-loss selling, it is important to ensure your tax strategy is based on accurate information. It is your responsibility (not your brokerage’s) to ensure your adjusted cost base (ACB) is accurate and up-to-date. This includes making adjustments for buys, sells, DRIPs, return of capital, reinvested distributions and unit splits. For more details on how to track your adjusted cost base, please feel free to download our white paper, As Easy as ACB.

When you file your tax return, any capital losses must first be used to offset capital gains you’ve incurred in the current tax year. Any remaining losses can be carried back for up to 3 years, or carried forward indefinitely to offset future capital gains. (To carry back current capital losses to prior years, you need to file form T1A – Request For Loss Carryback with your return.)

When Is It OK To “Sell Low”?

Back to that “selling low” conundrum. You may be wondering if it’s wise to realize a capital loss by selling a security that plays an important role in your portfolio.

If you’re holding individual stocks, it probably isn’t very wise. Say, for example, your Royal Bank shares are down in value, and you sell them to capture the capital loss. What if you then end up missing a big upward move in that stock?

To harvest the loss but not lose your position, you might figure you’ll just turn around and buy back more Royal Bank shares at the new, low price.

Nice try. But the Canada Revenue Agency (CRA) would declare your sale a superficial loss, and you wouldn’t be able to use it to offset gains. This is why investors who buy individual stocks have limited opportunity for tax-loss selling. And it’s yet another way ETF investors have an advantage. By following the techniques in this series of blog posts, you can systematically harvest capital losses, maintain constant exposure to all the asset classes in your portfolio, and comply with CRA rules.

The Superficial Loss Rule, in Two-Part Harmony

So, again, the CRA does not allow you to sell a security to crystallize a loss, immediately buy it back, and continue to hold it. If you do that, your claim will be denied as a superficial loss.

Bottom line, the CRA doesn’t think much of you playing shell games with your taxable holdings, so they require you to abide by a two-part superficial loss rule. And by the way, “you” includes people affiliated with you, which includes your spouse or a corporation controlled by either of you.

Whoever you are, you …

A. cannot buy, or have the right to buy, the same or identical property, during the period starting 30 calendar days before the sale, and ending 30 calendar days after the sale; and

B. cannot still own or have the right to buy, the same or identical property 30 calendar days after the sale.

In part A of this rule, the period spans 61 days: the settlement date of the sale, plus the 30 calendar days before and the 30 calendar days after the settlement date. Part B sounds redundant, but there’s an important subtlety. You can buy the identical security any time during the 61-day period, but you must ensure you don’t still own it by the end of the period. If you do, the loss will be denied and added back to the adjusted cost base of the identical security.

The 61-day period includes the settlement date of the sale as well as the 30 calendar days before and after the settlement date. We suggest first using your computer’s calendar to determine the settlement date of the sale. For an ETF, this is T+2, or two business days after the initial trade. When determining settlement dates, skip over any weekends or holidays when the Canadian stock markets are closed.

Next, count backward and forward 30 days starting at the settlement date (I’m not ashamed to admit, I count the days out loud like a first grader when determining the 61-day period). Ensure all purchases of the identical security settle outside of this 61-day period (unless you plan on selling the shares before the end of the 61-day period).

Similar vs. Identical Property

The good news for ETF investors is that you can avoid the superficial loss rule while still maintaining exposure to the same asset class by using similar, but slightly different holdings.

Remember, the superficial loss rule only applies if you sell and then repurchase the same security or an identical property. In 2001, the CRA issued a bulletin stating that two index funds tracking the same benchmark are considered identical property.

For example, according to this interpretation, you cannot sell the iShares Core S&P/TSX Capped Composite Index ETF (XIC) and replace it with the BMO S&P/TSX Capped Composite Index ETF (ZCN), as they both track the S&P/TSX Capped Composite Index.

Other less obvious examples of identical property would include the Mackenzie Canadian Equity Index ETF (QCN) and the TD Canadian Equity Index ETF (TTP), which both now track the Solactive Canada Broad Market Index. Vanguard, BMO and iShares all have funds tracking the S&P 500 Index, and these would also be considered identical property according to the CRA.

However, it is possible to find pairs of ETFs in the same asset class that are similar, but track different indexes. By selling your existing ETF and repurchasing a similar – but not identical property – you can realize a capital loss and still maintain similar diversification in your portfolio.

Identifying acceptable pairings can be time-consuming. In a separate post in this series, we’ll provide suggested ETF pairings for your consideration. Here, we’ll cover some additional details to bear in mind first.

Performance Considerations for Your Replacement ETF

As your replacement ETF is a similar, but not identical holding to your original ETF, it’s unlikely the pairs’ performances will be the same over the 30-day period.

For example, say you took a much-needed break from your in-laws on Christmas Eve 2018, to check on your portfolio. Yikes, you discover your $100,000 holding of the Vanguard FTSE Canada All Cap Index ETF (VCN) has dropped to $84,000! You sell all units of VCN and use the proceeds to buy the iShares Core S&P/TSX Capped Composite Index ETF (XIC), realizing a $16,000 loss in the process. After 30 days have passed, you sell your XIC holdings and repurchase VCN.

During this 30-day period, the replacement ETF happened to outperform the original ETF by about 0.15%, including dividends. This doesn’t seem like much, but on an $84,000 holding, it means you scored an extra $122 from your tax-loss selling round trip.

This is an ideal result, but things don’t always work out so well. There’s also a risk the replacement ETF will underperform the original ETF during the 30 calendar days after the switch.

If properly selected, your tax-loss selling pairs should have minimal tracking error, with minimal performance differences between them. This low tracking error is also a good reason to consider holding onto the replacement ETF, instead of switching back to your original ETF after 30 days. If both ETFs are expected to perform similarly going forward, and there’s no way to determine which will slightly outperform the other over your investment horizon, you’re really just flipping a coin at this point.

Partial Superficial Losses

It’s also possible to trigger a partial superficial loss, whereby only a portion of the capital loss is denied. This would occur if you or yours (as previously defined) buy back fewer shares of the identical property during the 61-day holding period, and you are still holding these shares at the end of the period.

This can easily occur when a tax-loss selling trade is made at year-end. When January arrives, investors and their spouses are busy making their TFSA contributions, simply topping up whichever asset class is down in value. This is often the same security they sold in December to realize a capital loss.

For example: You purchase 3,000 shares of VCN in 2018 for $100,000. On December 24 you sell all 3,000 shares for $84,000, resulting in a capital loss of $16,000. You immediately purchase XIC with the proceeds.

On January 9 of the following year (which is within the 61-day period), your spouse makes a TFSA contribution and buys 300 shares of VCN (which is the same security you just sold at a loss in December). Your spouse continues to hold these shares until after the 61-day period ends on January 27, 2019. Whoops! As your spouse purchased back 300 of the 3,000 shares you had initially sold, 10% of your $16,000 loss will be denied. This will result in a partial superficial loss of $1,600, reducing your actual $16,000 loss to $14,400.

Some spouses prefer to keep their finances separate, but this example illustrates the need for spouses to coordinate their investment strategies, especially when tax-loss selling.

Dividend Reinvestment Plans (DRIPs)

Enrolling in a dividend reinvestment plan (or DRIP) program through your brokerage account is also a surefire way to realize partial superficial losses. If you (or your spouse) have a DRIP set up on the same ETF that you decide to sell for tax purposes in your non-registered account, a portion of the loss may not be allowed. This is why we advise against using DRIPs when implementing a tax-loss selling strategy.

Continuing with our example, suppose your spouse also owns 3,000 shares of VCN in a TFSA that he or she purchased outside the 61-day window. In January 2019, your spouse receives a dividend from the fund, most of which is used to automatically purchase 20 additional shares of VCN. If these 20 shares are not sold by the end of the 61-day period, you’ve just triggered another partial superficial loss.

Multiple Portfolio Managers

Multiple portfolio managers can also cause unintended superficial losses. Some investors feel that using more than one manager offers some diversification benefit. The problem is, it can cause major headaches when it comes to avoiding superficial losses. If one of the managers sells a security to realize a loss, there is no way for them to know whether another manager is buying shares of the same security during the 61-day period.

Next Up: When Should You Sell Your Losers?

Okay, so we’ve now covered several important ways to avoid taking superficial losses as part of your tax-loss selling strategy. These include: keeping an eye on buying and selling similar, but not identical ETFs; avoiding partial superficial loss traps; and skipping DRIP programs as well as multiple portfolio managers. In our next post, we’ll continue the conversation by covering the tactics on when and how to apply tax-loss selling to begin with.

 

Special announcement: In the next CPM podcast, I’ll be discussing foreign withholding taxes. If you’d like to be featured on the episode, please record your question and email it to me (and if I can’t fit your question into the podcast, I’ll still provide you with an answer by email). I will also be including a new segment called Portfolio Improvement, so if you need some guidance on foreign withholding taxes in your own portfolio, please feel free to drop me a line.

Thanks everyone! :)