Bear Markets Can Create Opportunities for Tax Loss Selling

As you look at your investment statements and are depressed about the markets, there may be a silver lining. Bear markets can create opportunities for tax loss selling.

Tax loss selling is simply where you sell investments at a loss so that you can utilize the loss to save money on taxes. You must keep in mind that capital losses can only be deducted against capital gains and not other sources of income.

This year may be one of the best opportunities for tax loss selling because you can write off capital losses back 3 years. This means you can go back to your 1998, 1999 and 2000 tax year and deduct the losses incurred in 2001 against any capital gains.

This is good news for the following reasons:

  1. We had higher tax rates in the past. Federal and Provincial tax rates have come down dramatically in the past few years and you paid higher tax on capital gains in 1998 than you will in 2001.
  2. Along the same line of lower taxes, the amount of capital gains that is included for tax purposes have come down from 75% to 50%. If you incur losses today, you can deduct them against capital gains where you paid at a 75% inclusion rate instead of a 50% inclusion rate. The one thing to keep in mind is that loss this year must first be deducted against gains this year. Any excess can then be written off against any of the last three years – your choice.
  3. It is likely that there have been higher capital gains distributions in the last three years because of the bull market. Go back to previous tax returns and look for years where you had high distributions. Any losses can get your money back in taxes from previous years.

Some good advice

I was recently talking to Sal Tino, Executive Vice President and CFO for Clarington Mutual funds. He provided some good practical tips for tax loss selling:

  • In the Clarington Family of Funds they have a Class Structure or corporate structure (For more information on Class structures read my article Mutual Fund Corporations.). The idea is to crystallize losses and move to a like investment so that when the market rebounds, you will be in a similar environment. For companies with the tax structures, you can move from the non-corporate structure to the corporate structure. You have essentially the same fund but it is technically a different investment for tax loss purposes. Many other mutual fund companies have corporate structures.
  • You will have to use losses against any capital gains crystallized in 2001 first but it should be unlikely that there will be a lot of capital gains this year. Any excess capital losses can then be used against capital gains in 1998, 1999, or 2000. You have the control to decide which year will be the best year to take advantage of the deduction. In many cases you will want to go back to 1999 or 1998 because the tax rates, inclusion rates and distributions on mutual funds were much higher in those years.
  • You will need to use a T1A form to elect which year you want to utilize the losses.
  • Tax loss selling is simply a tax deferral strategy. You will have to eventually pay the tax but remember that the future trend for taxes is to have lower tax rates and lower capital gains inclusion. Tax deferral is a good strategy because you pay the taxes later which means you have more money to compound and grow in the mean time.
  • Be careful not to market time. Try not to use tax loss selling as an excuse to go into cash. You are better off sticking with long term investing and using a strategy like switching to a corporate class or a similar type of investment.
  • You must also understand the 30-day rule. You cannot sell an investment and buy it back right away. In fact, the government says that you must have been out of the original investment for a minimum of 30 days in order to be able to use the loss.

Be cautious with tax loss selling

Tax loss selling can be very beneficial from a tax standpoint but every financial strategy has good points and bad. One of the most important issues to maintain perspective in, is tax loss selling can be very complicated. In fact taxation is complicated. Tax loss selling will not benefit everyone. My advice is unless you are very analytical and have a good understanding of the tax and investment rules, get help. See your accountant or financial advisor before you do anything.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites JimYih.com and Clearpoint Benefit Solutions.

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