Tax planning is not reserved for the ultra wealthy. During market downturns, ordinary investors can take control of their tax burden through straightforward planning. In this article, we will describe how tax-loss selling can provide value to some investors, in the right situation. Please seek advice from your tax advisor and financial advisor to see if this tax-planning strategy is right for you.

Accessing the tax value of capital losses

If you own a property whose value has fallen below its original cost, you may be interested to learn more about tax-loss selling. Tax-loss selling is a strategy in which you sell property to intentionally trigger a capital loss. This could include a sale of personally owned non-registered investments like mutual funds or stocks, as well as other capital property like rental real estate. The strategy is not effective for property in a registered plan like an RRSP, RRIF, or TFSA.

When you realize a capital loss, half of the loss is used to offset your taxable capital gains for the year. A capital loss can only be used to reduce capital gains, not other types of income. It must be applied to your current-year gains first, but any excess allowable capital losses (a “net capital loss”) can be applied to other tax years at your discretion.

• A net capital loss can be carried back up to three years. A loss from 2022 can be used to offset gains in any of 2019, 2020, or 2021. This can entitle you to a tax refund for those previous years.
• A net capital loss can be carried forward indefinitely, for use against future taxable capital gains.

The amount of your loss depends on the tax cost of the investment. This cost is not always obvious, since it is affected by withdrawals, reinvestments, and any other identical securities you have acquired over time. If your investment is denominated in a foreign currency, the gain or loss is also affected by exchange rate fluctuations. You should always seek advice from a qualified tax professional before engaging in tax-loss selling.

When your capital loss is used to offset a capital gain, you avoid tax on that portion of the gain. Capital gains are taxed at rates of up to 24% in Alberta at 2022 rates. In the right situation – and depending on your tax bracket – there can be significant tax savings in accessing these losses.

Beware the superficial loss rules

Tax-loss selling does require some careful planning. It is important to consult with your tax advisor and financial advisor to guide the transactions. One potential roadblock to loss selling is the “superficial loss” rules, which discourage you from repurchasing an investment too near the time you sell it for a loss. 

If the superficial loss rules apply, your loss is denied and cannot be used to offset capital gains for the year. The superficial loss rules apply to an investment if:

• Within 30 days of selling that investment (before or after the date of sale), you or any “affiliated” person acquires the same investment or an “identical” investment; and
• At the end of the 30 days after selling the investment, you or an affiliated person continues to own that “identical” investment.

An “affiliated” person generally includes you, your spouse or common-law partner, and any entity controlled by one or more of those persons, among others. This means the rules cannot be avoided simply by having a closely related person buy an identical investment. The superficial loss rules will apply similarly if you acquire an identical investment in your registered accounts, like an RRSP, RRIF, or TFSA. A tax advisor should consider these superficial loss rules as a part of any tax-loss selling plan.

If your loss is a superficial loss, it cannot be used to offset your capital gains. Instead, the amount of the loss is added to the tax cost of the new investment. This will decrease the capital gain on that new investment or increase the capital loss, as the case may be, once it is eventually sold. In other words, if the superficial loss rules apply, the “denied” capital loss is effectively transferred to the replacement investment.

For example, imagine you sold 1,000 mutual fund units for $12,000 and realized a loss of $1,000. The next day, your spouse bought 1,000 units of the same mutual fund for $12,000. Instead of being able to use the $1,000 capital loss, it is treated as “superficial” and is added to the tax cost of the new investment. Your spouse would be treated as if they bought the mutual fund for $13,000 instead.

Remember your long-term investment strategy

The tax benefits of loss selling can seem attractive, but it is important that any tax strategy aligns with your investment strategy. The superficial loss rules sometimes convince investors to exit the market for 30 days or to switch to investments with different risks and returns. It can be dangerous to take on market risks solely in pursuit of a tax benefit.

Tax-loss selling should not be considered exclusively for its tax benefits. However, it may be a useful tool for the right situation, and something to consider when next reviewing your portfolio with your financial advisor or tax professional. As your life and personal circumstances change over time, your financial advisor may suggest changes to your investment plan to match those life changes. If you have a legitimate non-tax reason to sell capital property, it can be valuable to seek advice from a tax advisor about whether tax-loss selling is a good fit for your situation.

Conclusion

Tax-loss selling can be a helpful way to reduce tax on capital gains, whether in the current year or for carrying forward or backward to a different tax year. However, this planning should only be used when it aligns with your overall investment strategy and after careful consideration by your tax advisor. There can be additional tax considerations not discussed in this article (especially for corporate investors), so your tax advisor’s recommendations are integral.

If tax-loss selling is a reasonable strategy for your situation, please note that the investment in a loss position must be sold before the final settlement day for the year. For 2022, it would need to be sold on or before Dec. 28, 2022.