What Is Tax-Loss Harvesting? Selling Your Stock for a Tax Deduction
There are many strategies Canadian investors can employ to lower their tax burden. One obvious example is maximizing RRSP contributions, or contributing to a Spousal RRSP plan when it makes sense. You can even lower your tax bill when you save for your child’s education.
Tax loss harvesting (or tax loss selling) is a lesser known, yet fairly straightforward tax strategy that you can employ if you own a non registered investment account.
But how does tax loss harvesting work, and who qualifies? I’ll answer those questions and more in this guide to tax loss harvesting.
What Is Tax Loss Harvesting?
Tax loss harvesting occurs when you sell an investment at a loss in order to offset a capital gain that you’ve earned somewhere else. It’s a clever strategy that, if used effectively, can result in significant long-term tax savings.
How Tax Loss Harvesting Works
Let’s say you purchase $5000 worth of Company ABC stock in January. By March, the stock has dropped, and your investment is now only worth $4500. You decide to sell the stock, and purchase shares in Company XYZ, with the $4500 you have from the sale of Company ABC.
By September, Company XYZ’s stock price has jumped, and your $4500 is now worth $5300. You decide to sell all of your shares, realizing a capital gain. of $800. Because you incurred a loss of $500 earlier in the year, you can offset your $800 capital gain with your $500 loss, reducing your net gain to $300, thereby lowering your tax bill.
Understanding the Superficial Loss Rule
Before you consider tax loss selling, you need to understand a major limitation. It’s known as a superficial loss rule, and it says if you want to claim a capital loss on your taxes, you must wait 30 days before repurchasing the same investment you sold for a loss. The rule extends to people that you are in close relationship with. In other words, you can’t instruct your spouse to purchase the stock within 30 days either.
The Canada Revenue Agency enforces this rule for obvious reasons. Without it, you could create a superficial a tax loss scenario by maintaining your investment while reducing your capital gains tax.
Be Mindful of Year-End Deadlines
If you’re planning to offset gains in the current tax year but you haven’t yet incurred any capital losses, you have to realize your capital loss prior to the end of the calendar year. For 2022, you must place your trade by December 28th, so that it settles before the end of the year. Friday, December 30th, is the final day for stock trades to be settled.
Drawbacks of Tax Loss Selling
There is a clear tax advantage to tax loss harvesting, but there are a few potential drawbacks you should be aware of. Here are some reasons you may not want to employ this tax strategy.
Miss Out on Future Capital Gains
Anytime you sell a security, you are missing out on any potential future gains. Too many investors panic when their investments drop in value and sell. If you’re employing tax loss harvesting, make sure you’re doing it for the right reasons.
You May Have to Pay Fees to Sell
Depending on where you hold your trading account, you may be charged a trading fee to sell your investment. That might not sound too expensive, but remember than trading fees can add up over time, and eat into your returns.
It Might Throw Your Portfolio Out of Balance
Anytime you sell a security in your portfolio, you should double check to see if your portfolio needs rebalancing. Maintaining the optimal asset allocation mix of Safety, Income, and Growth in your portfolio is crucial to your long term success.
Tax Loss Selling FAQs
Does tax loss selling apply to registered accounts?
You cannot take advantage of tax loss selling in a registered investment, like an RRSP or Tax Free Savings Account (TFSA)account. These accounts are already tax-deferred, which means you aren’t taxed on the income while the funds are in the account. In the case of the TFSA, you will never pay tax on your investment income. Therefore, you shouldn’t stand to benefit from additional tax savings.
Can I use tax loss selling if I didn’t realize a capital gain?
No. You can only write off a loss against a realized capital gain. However, you can carry forward a tax loss indefinitely, and you can us it against any capital gains incurred going back three years. So, even if you can’t use your tax loss this year, you will be able to use it in the future.
What is an Adjusted Cost Base (ACB)?
The adjusted cost base of an investment is the cost used to calculate a capital gain or capital loss. It includes the original purchase price, and any expenses incurred to purchase the investment. For stocks, mutual funds, or ETFs, the ACB can include the original purchase amount, and any commission or trading fees.
Final Thoughts on Tax Loss Harvesting
Because of tax loss harvesting, capital losses don’t have to be a bad thing. If you’ve realized taxable capital gains in the previous three tax years, consider employing a tax loss harvesting strategy to offset those gains.
Take a look at your non-registered account. Are any of your stocks, mutual funds, or ETFs holdings sitting in a loss position? Do you have unclaimed losses from previous years that you can use? If so, consult a tax professional to find out whether it would make sense to offset capital gains with those losses.