Nobody likes to see their investments dip into the red. For beginner investors, the sight of a declining portfolio can be particularly disheartening.
However, there’s a strategy that might make these downturns a bit more bearable and potentially beneficial in the long run. It’s called tax-loss harvesting, and it could help you reduce the amount of capital gains tax you might owe when you sell other investments at a profit.
Essentially, tax-loss harvesting involves selling investments that have lost value to offset the capital gains you’ve earned from other investments.
By doing this, you can lower your taxable income and reduce the tax impact of your profitable investments. This guide will walk you through the basics of how tax-loss harvesting works in Canada. You’ll also learn how to start using this strategy to your advantage.
Key Things You Should Know About Tax-Loss Harvesting In Canada
- Selling investments at a higher price than the purchase price results in capital gains. A portion of these gains are taxable at your income tax rate.
- Capital losses occur when investments are sold for less than their purchase price. This potentially reduces tax on future gains or gains incurred in the preceding three years.
- Tax-loss harvesting allows investors to offset taxable capital gains with capital losses, effectively reducing their overall tax liability.
- The superficial loss rule prevents investors from claiming a capital loss for tax purposes if the same or an identical asset is repurchased within 30 days before or after its sale.
What Are Capital Gains?
Before diving into tax-loss harvesting, it’s important to understand what happens when you sell an investment in a non-registered account at a gain.
This is a taxable investment account that isn’t a Tax-Free Savings Account (TFSA), First Home Savings Account (FHSA), Locked-In Retirement Account (LIRA), Registered Education Savings Plan (RESP), or a Registered Retirement Savings Plan (RRSP).
Let’s consider an example. Suppose you own 30 shares of a hypothetical company called ABC Co., which you bought at $20 per share. This gives you a cost basis of $600 (30 shares * $20).
Imagine the company performs well and the share price rises to $40. You decide to sell all 30 shares at this higher price. This would turn what was previously only “unrealized” gains (gains on paper) into “realized” gains (cash in hand). By selling at $40 per share, your total sale proceeds amount to $1,200.
However, you need to pay tax on the profits. You calculate your profit by subtracting your original cost of $600 from the sale proceeds of $1,200. This results in a capital gain of $600.
In Canada, only 50% of capital gains of $250,000 and under are taxed, and 66.7% of gains over $250,000 are taxed. In this example, 50% of the capital gain of $300 is taxable at your marginal income tax rate, since it’s under the $250,000 threshold. This rule effectively reduces the tax impact of capital gains, making them an attractive component of investment returns.
What Are Capital Losses?
But what if your investment didn’t work out and you sold at a loss? Let’s suppose you own another stock, XYZ Ltd., of which you purchased 50 shares at $20 per share, giving you a cost basis of $1,000.
Now let’s assume XYZ Ltd. was caught in a bad accounting scandal, and its share price plummeted. After doing your due diligence, you decided cutting your losses was the safer route.
So, you sold XYZ Ltd. at a share price of $5 per share for 50 shares. The net proceeds would be $250. Your previously unrealized losses are now a realized loss of $750.
This isn’t a pleasant scenario, but it presents an opportunity to make the best of the situation through tax-loss harvesting.
How Tax-Loss Harvesting Works In Canada
Tax-loss harvesting is a method that can help you manage your taxes on investments. Here’s how it works, broken down into two simple components:
- If you sell an investment and lose money, this loss can help you reduce the taxes you owe on any gains you made from selling other investments in the same year.
- If your losses are greater than your gains, you can carry over this extra loss to lower your taxes on gains in the past three years or on any future gains.
Example Of Tax-Loss Harvesting In Canada
Let’s apply this to our earlier examples with ABC Co. and XYZ Ltd. stocks:
- You sold your ABC stock shares for a profit of $600.
- Meanwhile, you sold your XYZ Ltd. stock at a loss of $750.
Using tax-loss harvesting, you can offset the $600 gain from ABC with part of the $750 loss from XYZ.
This leaves you with a net loss of $150 ($750 loss – $600 gain = $150 remaining loss). You can carry this $150 loss forward to reduce capital gains tax you might owe in the future or in any of the past three years.
Watch Out For The Superficial Loss Rule!
You might be tempted to sell a stock at a capital loss to claim the tax benefit, then quickly buy it back to stay invested. However, the Canada Revenue Agency (CRA) has a rule to prevent this tax avoidance strategy called the “superficial loss rule.”
If you, or someone connected to you, buy the same stock again within 30 days before or after you sell it, you can’t claim the loss for tax purposes. Similarly, if you want to repurchase a stock like XYZ Ltd. and still claim a loss, you must wait at least 30 days after selling it.
If you don’t wait, then any loss you tried to claim becomes a superficial loss. This doesn’t count for tax reduction right away. Instead, this loss gets added to the cost of the new shares you buy. This means you can use the loss to reduce taxes only when you sell these new shares in the future.
The CRA considers properties identical if they’re the same in all important aspects, to the point where a buyer wouldn’t prefer one over the other. You can’t sell shares of one company and then buy shares of the same company to claim a loss.
