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While looking up online brokerages or investment portfolio opportunities, you've probably come across a concept known as tax loss harvesting. Briefly, the idea is a legal investment strategy that involves the selling of loss-incurring investment assets like stocks, Exchange Traded Funds (ETFs), and mutual fund shares to reduce the impact of tax deductions on capital gains realized from sales of other assets.
What is “Tax Loss Harvesting?”
Tax loss harvesting is a method of reducing your taxes on capital gains realized from the sale of certain investments. It's a strategy that's applicable only on taxable investment accounts and doesn't apply to TFSA or RRSP accounts.
For any investor, incurring a loss on assets, such as stocks or ETFs, is far from a desirable scenario. But as the saying goes, every cloud has a silver lining, and there is a silver lining for capital losses.
However, a strategy comes into play. The approach involves converting your losses from the sale of investable assets into a tax-saving gain.
Before moving forward (and for better clarity), let’s revisit the concepts of capital gains and losses.
- Capital gains are profits realized from the sale of an investment at a price higher than what you paid for.
- Capital losses are losses incurred on the sale of investments below their purchase price.
Online Brokerages and Robo Advisors that Offer Tax Loss Harvesting
One of the best online brokerages in Canada, Questrade has the edge over other discount brokerages when it comes to ease of use and lower fees.
Besides offering commission-free investing options in ETFs, Questrade also provides one of the lowest commission structures on stock trades. One of the best features about Questrade is that it offers portfolios that have tax loss harvesting tools built into them. This implies that portfolio managers at Questrade ensure you get the maximum tax benefits.
As one of the more innovative, automated platforms that invest your money for you, Wealthsimple offers people the chance to invest in a diverse portfolio. It also gives people with financial knowledge the choice to observe how their investments are being used within different portfolios.
Tax loss harvesting is automatically provided for all Canadian Wealthsimple Black and Generation customers. There is an option to turn it on or off from the settings menu. But the company highly recommends that not everyone should make use of this option. They say it's meant for passive investors.
ModernAdvisor is a robo advisor that builds a portfolio catering to your financial goals of wealth building, retirement saving, or creating a college fund. ModernAdvisor caters to many individuals from fresh grads to people close to retirement.
Their individual questionnaire determines your risk tolerance and builds your portfolio under those preferences. ModernAdvisor also offers the option of tax loss harvesting.
How Does Tax Loss Harvesting Work?
The concept behind tax loss harvesting entails that future capital gains can be taxed lower or in part because of capital losses incurred in the present. The strategy offers a silver lining, allowing investors to make use of losses by partially diminishing or negating taxes owed on gains realized.
The question then arises of a scenario where there are no gains made. In this case, there is still a legal provision to benefit from this scheme, as it can be carried forward indefinitely or can be used on gains made in the previous three years.
Let us look at the practical application of this concept. If in a particular year, you realized a loss of $5,000 and a gain of $1,000, the loss must apply to the profits of that year. This results in a net loss of $4,000, which can be carried forward or applied to previous year tax gains.
There are certain things to watch out for before using this strategy to offset gains. The first is that after applying for capital loss tax exemptions, an investor purchases the same security or stock within 30 days of the sale of the underlying asset. This is so people don't take advantage of the system by buying a recently sold security at a loss just to benefit from the tax exemptions. This is called the superficial loss rule.
On the other end of the spectrum, you can claim a loss on a particular stock or security you sold and purchase an identical one in the same industry (but not the same company).
For example, if you've disposed of shares in a Canadian mutual fund at a capital loss, but still want to benefit from the potential price hikes you anticipate, you can purchase an ETF that tracks the fund. This allows investors to pursue their desired investments without losing the opportunity of a tax loss harvest.
Selling Stocks to Claim the Capital Loss for Tax Purposes
Tax loss selling is a legal option for investors who want to diminish their tax liability. If an investor owns shares that have dropped in value beyond what they paid, the investor can sell these shares for a loss and deduct the loss against capital gains for a reduced year-end tax bill.
Again, the loss must first be applied to capital gains of the same period. Any leftover losses can still be carried forward without a time cap or be used to cover capital gains realized from three previous years.
The question then arises of whether you should wait for the prices to bounce back up or sell the stocks for a capital loss to see the benefit of a tax advantage. Often, the most optimal stocks for trading in a portfolio are stocks that the investor doesn't anticipate will rise in value in the foreseeable future.
If you think a stock is going to pick up and is only down because of market speculation and not for financial or legal reasons, think twice before selling. A rule of thumb for such scenarios is to let financial and common sense prevail over potential tax benefits.
You have to be wary of a few things before claiming a capital loss for tax advantages:
- The trade must be completed before December 31, and the settlement date is set three business days after the claim is filed. Counting Christmas and Boxing Day holidays, the most optimal day for taking advantage of tax-loss selling for the Canadian market is December 24.
- If an investor based in Canada were to complete a trade for tax-selling purposes, it would be marked as a tax advantage for the following year.
- Your capital loss claim for tax-selling purposes is considered invalid if you repurchase the same stock before or after 30 days of the settlement date. The rule for stocks is the same as previously mentioned superficial loss. You cannot get around it by having a business you or your spouse controls, or purchase the same stock.
There is a way around the superficial loss rule though. It involves buying shares in similar companies or investing in mutual funds within the same industry.
For example, suppose you own stock in a mining company and the value dropped because of some legal troubles the company was facing. You sold the shares to apply for tax saving benefits on the capital losses realized.
If you are still interested in keeping the mining industry for your portfolio, you could buy shares of a competitor or invest in a mutual fund in the same industry.
Stocks have proven to be the most optimal investment assets that take advantage of this tax scheme. That's because even individual investors with little or no financial knowledge can easily calculate their capital losses for different stocks of various companies.
They can use the information to offset their losses against their capital gains without using complicated software or paying extra to trading platforms.
Loss-making stocks can also be sold and replaced by more financially healthy alternatives without the pain of losing too much as the tax impact would be reduced or negated altogether.
Benefits of Tax Loss Harvesting
The main advantage of tax loss harvesting lies in tax reductions. Upon the sale of a security that has dropped in value since the purchase, the loss is used to offset profits from capital gains for a reduced tax rate.
The critical thing to consider here is that tax loss harvesting applies on both long-term investments (over a year) and short term (held less than a year). An order is applied to capital losses incurred from these two different investment horizons.
Long term capital losses are first aligned with long term capital gains and subsequently with short term gains. But short term losses are aligned first with short term gains. The reason behind this order is because long term capital gains are taxed at a reduced rate relative to short term gains.
This sequence is beneficial to an investment portfolio, as it allows the portfolio to outpace losses and grow at an increasing pace relative to if the money paid towards taxes had not been reduced besides the losses incurred.
The other advantage that tax loss harvesting offers is when it comes to the rebalancing of your financial portfolio. When you've loss incurring assets in your portfolio, you can sell them off. The pain is numbed by the promise of a tax reduction, instead of anticipating a rise in value which might never come.
Use Tax Loss Harvesting for Better Investment Returns
Tax loss harvesting is more useful and has a more significant effect on investment portfolios over time. The concept is beneficial for investors who want to rebalance their portfolio and get rid of loss incurring assets. They can offset it against short term gains taxed more heavily.
The best way to optimize tax loss harvesting is to integrate it as part of your portfolio rebalancing, as they go hand in hand. This serves as a strategic advantage for rebalancing your portfolio in line with your desired investments while rooting out low performing assets.
How Capital Losses Can Be Used to Offset Capital Gains Use
Capital losses occur when investment assets are sold for less than their purchase price. Capital gains are taxable – which implies that capital losses can be deducted from the gains to reduce the taxable bill. However, certain conditions can be used to offset capital gains.
- Leftovers from the sale of capital property are calculated by taking the selling price and deducting any costs incurred on the sale. The adjusted cost base is the purchase amount an investor paid, including any additional capital outlays over time.
- Capital property includes tangible and intangible assets bought with the intent of possession for some time until the value increases. Examples are real estate, trademarks, and patents.
- Capital losses can only be aligned against capital gains and cannot be used to influence tax of other revenue streams such as income or dividends.
- Capital gains are first applied to losses within the same period, and if the losses outweigh the gains, the remaining capital losses are transferred to an account called the net capital loss.
Since capital losses can be used in any future years, it's hard to keep track of the exact balance you've left. There are two main ways to discover whether you can offset the current year capital gains against previous year capital losses:
- Refer to your Notice of Assessment, as it will be clearly mentioned there.
- Access the information online by logging into the Canada Revenue Agency My Account. From there, find the link to Tax Returns. Click on it and search for the option of Carryover Amounts. The information you seek is on the Carryover Amounts page, which clearly indicates the remaining balance of your capital losses that can still be offset.
The Bottom Line
Tax loss harvesting is a method of converting investment losses into tax savings. The idea is to dispose of investments that have gone down in value and save money in taxes. It makes sense only in specific scenarios.
Industry experts recommend using tax harvesting only if the investor doesn't plan on a massive withdrawal within the next year and is invested in a non-registered account.
You can attempt tax loss harvesting on your own, but if you've got multiple investments, the process can prove to be quite complex. If you are using an investment platform that offers tax loss harvesting as a premium service, check the fees before signing up. Additional charges for tax harvesting could eat into any gains realized from the plan, or worse, cost you more than your gains.
As a strategy, tax loss harvesting should not be actively pursued, as it's a means of tax reduction and not increasing or saving your wealth. It's a reactive strategy and not a proactive one.
However, not everyone can invest like Charlie Munger or Warren Buffet, and the rest of us need a cushion our fall occasionally. If that cushion is converting our losses from capital sales into tax savings, it's a better scenario than having no buffer.
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