It has been a rough year for the stock and bond markets. For investors with a globally diversified and risk-appropriate portfolio, especially in tax-advantaged accounts like RRSPs and TFSAs, it's perfectly sensible to stay the course and wait for your investments to recover — as they eventually do. But if you took a loss on your non-registered investments this year, tax loss harvesting can be a way to turn a loss into a tax advantage.
What is tax loss harvesting?
Tax loss harvesting is not an exotic strategy reserved for the wealthy. It's a straightforward tax savings concept that involves selling an investment for less than you paid for it, then using that loss to offset an investment gain.
More plainly, selling an investment held in a non-registered account is a taxable event. If the investment is sold for more than the original cost, the taxpayer incurs a capital gain and 50% of that gain is added to their taxable income in the current tax year. If the investment is sold for less than the original cost, the taxpayer incurs a capital loss. These losses can be used to offset capital gains that have occurred in the past (up to three years), present (the current tax year) and future (indefinitely).
Savvy investors and investment advisors use tax loss harvesting in various ways to save on taxes or reorganize an investment portfolio. Here's how it works.
Tax loss harvesting in action
Suppose you hold a Canadian equity mutual fund or ETF that you purchased last year for $100,000 and hold in a taxable account. Today, the current market value of your fund is worth $90,000.
With tax loss harvesting, you would first sell all units of the Canadian equity mutual fund or ETF for $90,000. This taxable event triggers a $10,000 capital loss.
Next, you'd immediately purchase $90,000 worth of a comparable Canadian equity mutual fund or ETF. "Comparable" means it tracks a different index than the original fund that you held. An example would be the FTSE Canada All Cap Index versus the S&P/TSX Capped Composite Index.
You're still fully invested with $90,000 held in Canadian equities, but you've just "harvested" a $10,000 capital loss that you can apply against a capital gain incurred up to three years ago, during this current year or in any future year.
Purchasing a comparable fund that tracks a different index gets around the Canada Revenue Agency's “superficial loss” rule, which states that investors can't repurchase the same security for 30 days or the agency will disallow the capital loss.
But as a savvy investor, you know that staying out of the market for 30 days can lead to an opportunity lost. A lot can change in one month, and having your money on the sidelines can mean missing out on investment gains. That's why you would invest immediately in the comparable fund.
When to use tax loss harvesting
Tax loss harvesting can be done at any time during the year, but most investors and their advisors will use the last three months of the year to evaluate their portfolios and their tax position before deciding whether to use the strategy.
Investors with large taxable investment accounts may not want to trigger capital gains during their working years or during a period of high stock prices.
A market downturn can offer investors the opportunity to reorganize or simplify their non-registered investments and take advantage of lower capital gains or capital losses, if investments have dropped below their original cost. An example might be a non-registered portfolio of individual stocks where the investor wants to move to a balanced mutual fund or ETF.
Alternatively, perhaps you're invested in a more expensive mutual fund or ETF and want to switch to a comparable, yet less expensive, fund. Tax loss harvesting gives you the opportunity to switch your investments and claim a capital loss.
Finally, a sharp market decline (like the one in March 2020) presented a brief window for investors to take advantage of tax loss harvesting. The subsequent swift recovery highlights the importance of immediately purchasing a comparable fund to stay fully invested.
Deadlines to watch for
Those looking to harvest capital losses should be mindful of executing the strategy too close to the end of the calendar year. That's because stock, mutual fund and exchange-traded fund trades take time to settle — two days after the transaction date.
This means, for example, when December 31 falls on a Friday, the last trading day for the year will be Wednesday, December 29. Any trade made after this date will be settled in the next calendar year.
Investors should also be aware of stock market closures around the holidays. For instance, the Toronto Stock Exchange is closed on Christmas Day and Boxing Day.
The other deadline to keep in mind is the rule for applying a capital loss to a capital gain reported to the Canada Revenue Agency (CRA) during the previous three years. If you don't have the opportunity to trigger a capital loss until four years have passed (since you reported a gain) then you cannot use the loss to offset that previously reported gain, but you can use it against current year gains or carry it forward indefinitely.
What types of assets does tax loss harvesting work with?
Capital gains or losses are incurred when an asset is sold or deemed sold.
Selling investments held in tax-advantaged accounts such as an RRSP, TFSA, RESP or LIRA does not trigger any tax consequences. Similarly, your principal residence is not subject to tax when sold. But an investment held in a non-registered account, as well as a rental property or cottage, is subject to capital gains or losses when sold.
Tax loss harvesting works best with investments (stocks, bonds, mutual funds, ETFs). But let's say you sold a rental property last year and incurred a capital gain of $40,000. This year your non-registered investments are down $20,000.
A tax-loss harvesting strategy may be to sell your non-registered investments to trigger the $20,000 capital loss, then immediately purchase comparable investments. Then, when you file your taxes for the current year you can apply the $20,000 capital loss to partially offset the capital gain incurred from the rental property disposition last year.
Tax loss harvesting is a smart strategy for investors to take advantage of when they have the opportunity to trigger a capital loss. These capital losses can be used to offset any capital gains incurred in the past three years, the current year or in any future year.
Investors can also use tax loss harvesting to reorganize their portfolio into more appropriate or less expensive investment funds.
As a physician, you may have a healthy non-registered investment portfolio and wonder if tax loss harvesting is an appropriate strategy for you. It's a good time to reach out to your MD Advisor* and potentially turn an investment loss into a tax advantage.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.