When the stock markets aren’t offering opportunities to make money, there are sometimes ways to come out ahead by paying less tax. Here’s how:
Tax Loss Harvesting
Many investors know that 50 per cent of a capital gain is taxed as regular income to the earner. The same principle applies to capital losses; 50 per cent of the gross loss can be applied against the taxable portion of capital gains. Tax loss harvesting involves selling securities at a loss, then using that loss to offset capital gains.
Capital losses must be used against capital gains in the current tax year or the previous three years or carried forward indefinitely to offset future capital gains.
Which losses are eligible?
Capital losses on securities are most commonly used in this strategy, but losses from personal loans, private business investments or real estate could also meet the requirements.
Only losses incurred in a non-registered account qualify. Losses incurred in a registered account such as a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) are not eligible. This is because a capital gain itself is not taxable in these accounts.
Consider risk reduction
Due to the bull market of the past decade, many Canadians built up large, looming capital gains in their investment accounts. Some of these same people may own losing stocks that they don’t expect will recover. These people may wish to sell the depressed stocks at a loss and taking profits on some of their winning stocks, thus reducing risk and rebalancing their portfolios in a tax-efficient manner.
Superficial loss rule
When tax loss harvesting, be wary of the superficial loss rule. Buying back the same asset within 30 days deems the resulting loss as superficial, therefore disqualifying the capital loss.
This rule applies not only to the taxpayer, but also to his or her related parties, including their spouse, business partner, business or trust. Likewise, transferring losing shares to an RRSP is also considered a non-arm’s length transaction.
Buying back a similar asset within 30-days also disqualifies the loss. For example, selling a losing ETF and buying a different one that tracks the same index could be considered identical properties, deeming the loss ineligible.
There is, however, one way in which the superficial loss rule can work for investors: If one person has significant portfolio losses and their spouse has significant gains, that person can sell their shares and have their spouse acquire the same shares within 30 days. The denied loss is added to the cost base of the spouse’s holding, allowing for a potential future sale at a loss.
Other helpful strategies
Knowing all of the tax-saving options available is beneficial. Those with complicated lives should use an accountant to ensure they are using all deductions available to them. Here are a few to keep in mind:
Donating publicly listed securities with accrued gains to registered charities usually does not trigger capital gains, meaning the shares could be transferred tax-free, plus the donor receives the donation tax credit.
Divorce or separation may trigger capital losses when transferring non-registered investments to one’s spouse.
Capital losses aren’t the only way to offset gains. For example, selling a private company or farm property could qualify for the lifetime capital gains exemption. Further, losses on private investments may qualify as an allowable business investment loss (ABIL) that can be used against any source of income in the year claimed.
With proper planning, there are many opportunities to recover money on losing investments. Sometimes this comes in the form of reducing taxes today, deferring taxes in the future, or recover taxes paid in the past.As with any tactic, use caution when tax loss selling. Be sure to discuss suitability and proper execution in advance with your financial advisor.