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Take Advantage of Capital Losses

In a year when we have seen plenty of losses, investors should think about taking advantage of capital losses for future gains. But what is the best strategy to follow? Which investments do you sell and which ones do you keep?

If you've decided to sell a security (like a mutual fund) that has an accrued gain, you've increased your taxable income. However, when you sell a security that has an accrued loss, the capital loss will reduce your capital gains for that tax year. When losses exceed gains in a given year, there is no further reduction to your current taxable income. However, a capital loss can be used to reduce your capital gains in any three previous tax years or can be carried forward indefinitely to reduce future gains.

Sell or Hold?

If your portfolio contains an investment that has declined in value to the point that its market price is below your original cost, you have what is called an accrued loss. An accrued loss is a paper loss, and for tax purposes, until the loss is realized and the investment is disposed of (i.e. sold), it doesn't exist.

Remember, a capital loss is not considered a tax deduction; you can benefit from a capital loss only when there are capital gains. The loss is first applied against capital gains realized in the same tax year. Excess capital losses are accumulated and can be carried back to any of the three prior years or forward to any future year where there are capital gains. As a rule of thumb, always look first to past years to determine if capital gains took place. A capital loss that is carried back reduces income taxes payable for that year and will result in a refund of taxes already paid.

What about tax loss selling?

The strategy of selling an investment to create a capital loss is commonly referred to as "tax loss selling". It can be an effective way to reduce your total income tax liability.

If you are selling a security near the end of the calendar year and you want to have the loss be included in that tax year, you must sell the property early enough for the trade to settle by December 31.

Superficial Loss

When you realize capital losses, you should be aware of the superficial loss rule that may deny a capital loss realized on a sale of a security. This rule generally applies to the disposition of any security by an individual if:

i) during the period that begins 30 days before the disposition and ends 30 days after the disposition you acquired the same or identical property

and

ii) at the end of the period you owned or had a right to acquire the same or identical property (Canada Revenue Agency refers to this as a substituted property).

If the superficial loss rule is triggered, the capital loss realized personally on a disposition is denied, and is added to the cost of the substituted property. For example, you purchase a security for $7,000 and later sell it for proceeds of $5,000; there is a $2,000 capital loss that can be used to offset capital gains. However, if you purchase an identical/substituted property within 30 calendar days of the sale, let's say for $5,200, the superficial loss rule applies. This means that the $2,000 capital loss is denied, but it is added to the cost base of the substituted property so the "new" adjusted cost base of the substituted property becomes $7,200 (the $5,200 cost plus the $2,000 denied). This is why it is important to understand tax loss selling and its benefits.

Conclusion

As you review your investment portfolio with an eye to making adjustments, it is important to remember that while taxation is a factor you should consider, it is not the primary motivation for an investment decision. Your investment goals, risk tolerance, and the fundamentals of the particular investment should guide your decision.

For income tax advice regarding your specific situation, consult with your tax professional prior to implementation of a tax loss selling strategy. If you would like to review your current holdings and their positions, please contact our office for a consultation.

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