Tax Loss Selling – Why Do It?

Buy Low, Sell High is the classic phrase you’ll hear in investing. Well, tax loss selling (also known as tax loss harvesting) suggests you do something different: sell low and buy low. The recent fall in bond prices have created losses that have not been experienced by long-term stock investors, giving us an opportunity to harvest tax losses.

Tax Loss Selling is a strategy where you sell your investments when they are down, so you can capture a taxable loss. You then turn around and purchase a very similar (but not identical) investment, so you maintain your market exposure while capturing a tax loss. Here’s an example.

You hold Canadian Equity Fund A (Fund A), which has fallen in value by $25,000 from your purchase price of $100,000 (the Adjusted Cost Base). You sell Fund A for $75,000 and immediately buy Canadian Equity Fund B (Fund B). Fund B essentially holds the same thing as Fund A but tracks a different index. Let’s assume the market has remained flat and after a month Fund B is still worth $75,000. You sell Fund B for $75,000 and rebuy Fund A. At tax time, you see that you realized a capital gain of $5,000 on US Equity Fund C this year. You report your $5,000 gain from Fund C, claim the $25,000 loss from Fund A, and a $0 gain from Fund B. That reduces your taxable capital gains to $0 for the year and gives you a Net capital loss of $20,000 that you can carry back 3 years or carry forward indefinitely. The adjusted cost base on the Canadian Equity investment is now $75,000, rather than $100,000.

My colleagues Justin Bender and Dan Bortolotti created a comprehensive guide to Tax Loss Selling if you’re looking for more information about the rules and mechanics of completing tax loss selling trades.

I will focus on the underlying reason for using this strategy, the benefits, potential drawbacks, and how to claim the losses on your taxes.

The Reason to Tax Loss Harvest

As the name implies, this strategy is solely used for tax reasons and is only useful in taxable (i.e. non-registered) investment accounts. The goal is to replace the security that you are selling (original security) with a nearly identical security (replacement security) to maintain the same investment exposure. If you are selling a security which doesn’t have a good substitute (e.g. individual stocks or funds that have an uncommon investment philosophy/methodology), you run the risk of selling when markets are down, but not capturing the potential upside of a recovery in your preferred investment fund. From CRA’s perspective, two broad-based market ETFs are different if they track a different index. For example, you could sell one Canadian ETF and purchase a similar one (tracking a different index) and maintain your exposure to the Canadian market. This allows you to capture the taxable loss, use it to reduce taxable capital gains now, but stay invested to capture future growth. Therefore, ETFs are ideal vehicles to be able to capture tax loss harvesting opportunities. This may sound too good to be true. However, it’s not tax avoidance, since you’ll still end up paying the capital gain down the road. Since you’re purchasing the new security at a lower relative price, you’ll have a lower Adjusted Cost Base than you previously did and a higher capital gain when the investment recovers and is ultimately sold.

If you still have to pay the tax man, why do it at all?

The main benefit of tax loss harvesting is tax deferral, especially if you can use the tax loss in a year when you are in a higher tax bracket and claim the ultimate capital gain when you are in a lower tax bracket.

If you capture the loss and carry it forward until you resell the same security with the loss baked into the lower ACB, then you don’t benefit from tax loss harvesting. However, if you can invest more earlier as a result of using capital losses, you gain a tax advantage. The advantage exists if you remain in the same tax bracket and is even higher if you fall into a lower tax bracket when realizing the larger capital gains down the road. Implementing tax loss harvesting while understanding the client’s recent, current, and expected tax situation through financial planning allows Portfolio Managers to increase after-tax returns. Some examples of this are:

Selling employer shares:

Perhaps you sold a large portion of your employee shares and had a lump sum to invest. The initial sale of the shares had a large capital gain associated with them and pushed you into the highest tax bracket and resulted in a decent chunk of those proceeds being sent to the CRA. If you were able to claim capital losses from your new diversified investments against those capital gains, you will get some of that tax back which can be invested. This allows you to earn an investment return on a larger pot and potentially claim the capital gain when you’re in a lower tax bracket.

Let’s take an example and assume that you can claim the capital loss against your prior year taxable gains immediately and get the tax refund right away. We’ll also assume that you were able to swap back to the original investment with no realized capital gain or loss or transaction costs.

Assume you hold Canadian Equity Fund A (Fund A), which has fallen in value by $25,000 from your purchase price of $100,000 (the Adjusted Cost Base). You sell Fund A for $75,000 and claim a net capital loss of $12,500 against your 2021 taxable capital gains at the highest tax bracket in Ontario (53.53%). You would get a tax refund of $6,691.25 which could be invested into Canadian Equity Fund B (Fund B) alongside your $75,000 proceeds from selling Fund A. 10 years later you sell your Canadian Equity holding, which has grown 5% a year for 10 years for proceeds of $133,066.44. Since you’re only in the 43.41% tax bracket your net proceeds are $121,915.45. If you did nothing and continued to hold onto Canadian Equity Fund A the whole time, you would end up with $117,355.73. Using tax loss selling in this example delivers a gain of 3.9% compared to doing nothing.

	Tax Loss Harvesting	Do Nothing
	2022	2032	2032
Adjusted Cost Base	100,000	$81,691.25	$100,000
Current Value	$75,000	$81,691.25	$75,000
Sale Proceeds	$75,000	$133,066.44	$122,167.10
Capital Gain/Loss	-$25,000	$51,375.19	$22,167.10
Taxable Capital Gain/Loss	-$12,500	$25,687.59	$11,083.55
Tax Rate	53.53%	43.41%	43.41%
Tax Refund/Owing	$6,691.25	-$11,150.98	-$4,811.37
Net Proceeds	$81,691.25	$121,915.45	$117,355.73

Rejigging Your Portfolio:

If you had a portfolio full of individual securities and you wanted to diversify and invest in broad-based ETFs (i.e. “passive” investments) going forward you may need to realize some large capital gains as a result of that portfolio change. Like the previous example, if you perform tax loss selling when your investments are down and carry back those losses, you can invest more now using the tax refund compared to leaving the losses unrealized. The previous example would also apply to this scenario.

Rebalancing:

Investment portfolios often require rebalancing if you aren’t regularly contributing cash to the portfolio or if market moves are significant enough that cash additions aren’t sufficient to rebalance back to target weights. If you have capital losses available from tax loss harvesting, when you rebalance and sell securities at a profit, you can utilize those tax losses, rather than paying the capital gains tax out of pocket (reducing the amount you can save) or from the portfolio (reducing your investment value). By saving more or maximizing the value of the investment portfolio, you can give your money more time to grow before having to pay taxes.

Ultimately the size of this benefit will depend on a number of factors, such as the future capital growth of the investment, how long you’re invested before selling at a gain, what tax rate you’re in when claiming the capital gain, etc. The higher the return, the longer the investments can grow, and the lower your tax rate upon realizing the ultimate capital gain, the larger the advantage of tax loss harvesting.

As in the previous example, your $100,000 investment has fallen to $75,000 and you make a tax loss harvesting trade to capture $12,500 in a net capital loss which you hold onto until you have a gain from rebalancing in 2032. Because you had the net capital loss to use, you don’t owe any taxes in the rebalancing trade. This allows your full proceeds to be invested until 2042 when the portfolio is ultimately sold and taxes are paid. We compare that to an example where you didn’t sell in 2022 to harvest losses to carry forward. All investments earn 5% per year.

Carry Forward Tax Losses

	Investment A	Investment B	Investment A & B
	Tax Loss Harvesting	Rebalancing	Total Portfolio Sale
Transaction Date	2022	2032	2042
ACB	$100,000.00	$100,000.00	$200,000.00
Current Value	$75,000.00	$125,000.00	$402,609.16
Proceeds	$75,000.00	$125,000.00	$402,609.16
Capital Gain/Loss	-$25,000.00	$25,000.00	$202,609.16
Taxable Capital Gain/Loss	-$12,500.00	$0.00	$101,304.58
Tax Rate		53.53%	53.53%
Tax Refund / Owing		$0.00	-$54,228.34
Net Proceeds	$75,000	$125,000	$348,380.82

Don’t Tax Loss Harvest

	Investment A	Investment B	Investment A & B
Transaction Type		Rebalancing	Total Portfolio Sale
Transaction Date	2022	2032	2042
ACB	$100,000.00	$100,000.00	$218,308.75
Current Value	$75,000.00	$125,000.00	$391,709.82
Proceeds		$125,000.00	$391,709.82
Capital Gain/Loss		$25,000.00	$173,401.07
Taxable Capital Gain/Loss		$12,500.00	$86,700.53
Tax Rate		53.53%	53.53%
Tax Refund / Owing		-$6,691.25	-$46,410.80
Net Proceeds		$118,308.75	$345,299.02

What If’s

Capital Gains Inclusion Rate

There has been talk about the government increasing the capital gains inclusion rate since the Liberals came into power in 2015. The current capital gains inclusion rate is 50%, but it has been as high as 75% in the past:

Year	Inclusion Rate
Before 1988	50%
1988 & 1989	66.6667%
1990 to 1999	75%
2000	See Your Notice of Assessment
2001 to 2021	50%

If you carry forward the capital losses, then there is a mechanism for updating your capital losses to be equivalent to the current inclusion rate. Therefore, if you’re carrying forward your capital losses and the capital gains inclusion rate increases, you don’t lose because of capturing losses when the inclusion rate is lower.

However, if you claim the losses against capital gains at the current inclusion rate, invest the tax refund, but the capital gains inclusion rate increases when you ultimately sell the securities, you could potentially pay more tax on the investment as a result since your lower ACB results in a larger future capital gain, which is taxed at a higher capital gains rate. Again, the return, time horizon for the investments, and tax bracket when you ultimately sell the investment makes an impact on whether tax loss harvesting will come out ahead.

Our recommendation is not to try and anticipate future tax changes and focus on the things that we know and control.

What happens if markets go down subsequently?

Based on the superficial loss rules, you need to hold onto the replacement security for a period of 30 days before you can switch back to your original investment. If markets continue to fall, you can swap the securities and claim an additional capital loss.

What happens if markets go up?

Markets could also increase during the 30-day period where you are holding the replacement security. The impact depends on the amount of a market recovery. If the replacement security only increases by a small amount, you could swap back to the original fund, capture a small gain on that transaction, use the original loss against that gain, and carry forward or back the difference. Using bonds to tax loss harvest (given current bond performance) provides an opportunity to harvest losses, with lowered risk that the original security will recover within the 30-day window.

If it’s a large recovery and the replacement security rises higher than the original value of the investment, you may end up with a net capital gain when switching back to the original investment. Therefore, it’s important to understand what you are replacing the original investment with, and how similar their performance is. This will help you decide if tax loss harvesting is worth the potential risk of diverging performance if you want to hold onto the replacement security and avoid realizing a net capital gain. If the substitute investment is a nearly identical investment, you can simply hold onto the new ETF rather than capture a taxable gain.

How to Make Use of Losses?

Under the tax rules, you must use your capital losses against any capital gains in the current year. If there are more losses than gains, you have a net capital loss. The net capital loss cannot be used to offset regular income like employment income. However, you are able to carry back capital losses for 3 years or carry it forward indefinitely. The net capital loss will be calculated on Schedule 3 of your tax return.

In order to carry back the net capital loss, you complete Form T1A, Request for Loss Carryback. You can select any of the past 3 years to claim the net capital loss against, which gives you the ability to use the loss against years where your tax rate is highest. Carrying back losses will adjust your taxable income in the prior year, which results in a refund (assuming you didn’t have back taxes owing). However, the capital loss won’t change your net income or change any income-tested benefits. If the capital gains inclusion rate was the same in all years (which is the case at the time of writing this), then no adjustments will have to be made. However, if the current capital gains inclusion rate is different from the inclusion rate in any of the 3 previous years, you will have to adjust the capital loss to carry back. For 2022 net capital losses, you can apply the net capital loss to 2019, 2020, or 2021 capital gains.

If you don’t have capital gains in the previous 3 years to apply your net capital loss to, you can carry forward that loss indefinitely. When you do have a capital gain, you could use those net capital losses from previous years by claiming a deduction on line 25300 of your tax return. If the capital gains inclusion rate is different in the year you are claiming the net capital loss than when you realized the loss, you’ll need to make an adjustment to the net capital loss.

Summary

In summary, tax loss harvesting can be a tool in your investment management arsenal to help defer and possibly lower tax rates on capital gains. However, the benefits of tax loss harvesting will depend on a number of factors including:

Tax rate when harvesting losses and tax rate when paying the ultimate capital gains
Capital gains inclusion rate when eventually selling at a gain
How well an investment can be substituted with a tax loss selling pair
Performance of original security and replacement security after the tax loss harvesting trade has been made
Amount of time invested before gains are ultimately realized

Because many of these factors are unknown when a tax loss harvesting opportunity is presented, the investment strategy should take priority over the tax deferral benefits. You want to avoid harvesting losses at the expense of not being invested in the same/similar investments during the 30-day period. This makes tax loss harvesting ideal for broad-based market ETF’s where similar investments can be substituted and held onto for the long-term. Identifying and acting on these opportunities is the responsibility of a good Portfolio Manager even if their client does not see the benefit for several years.