As the economic fallout from the COVID-19 pandemic continues to wreak havoc on investors and their portfolios, many are feeling particularly helpless. But there is one thing investors can do to take advantage of the market chaos: use tax-loss harvesting techniques on their losing stocks to generate significant tax savings down the road. Tax-loss harvesting means intentionally locking in stock market losses to create a tax credit that can be applied to capital gains taxes owed. You’re locking in a loss now that can be used either against a potential gain in the future or used to offset a gain already booked in a previous tax year. We’re talking tens of thousands of dollars if you have a large portfolio.
Let’s take a closer look at this under-utilized investing strategy, including an overview of the process, how you can use it to your benefit, what pitfalls to avoid, and, most importantly, how it can save you cash at tax time.
Should I Turn On Tax-Loss Harvesting?
The ideal time to use tax loss harvesting is during periods of market downturn, like we’re experiencing today. With uncertainty ruling the day because of COVID-19, most of your investments will likely be losing money. This means you’ll have your choice of many different stocks to sell. It also means the investments you choose to replace them with will be similarly impacted.
Remember, COVID-19 has changed the long-term future for many industries. Airlines may never recover. Hotels will likely be impacted for years to come. Even the need for office space might be permanently impacted as many employees continue working from home. In this new world, it would make sense to sell those investments. Tax-loss harvesting can be the impetus for an investor to do the right thing for their long-term wealth.
COVID-19 aside, the other situation where it’s advantageous to tax loss harvest is when you’ve decided to sell a stock for a big gain. Perhaps the company has been taken over at a premium, or maybe you’ve just decided to lighten exposure to it. You’d then offset the sale of your winning stock with a losing one to minimize taxes owing.
The Advantages of Tax-Loss Selling During COVID-19
With COVID-19, the advantage of tax-loss harvesting right now is primarily timing. Just about every stock has gotten hammered, with some names down 50% or more. You’ll have your choice of names to sell. And since entire industries are down, it’s easy to replace a stock with the competition and still ensure similar upside potential when things inevitably recover. The process of choosing a suitable substitute investment is a lot harder in a bull market.
Let’s say your salary is $100,000 per year. But your investment portfolio is currently down $50,000 from its cost basis and, conveniently enough, you just booked a capital gain of $50,000 on an unrelated asset. This means that instead of owing capital gains taxes on a $50,000 profit, the tax-loss harvesting strategy would effectively reduce your investing taxes to zero.
Even if you’re looking at a potential tax savings of a few hundred dollars, this strategy still makes sense. After all, it’s not much more complicated than a few mouse clicks and a couple of extra pieces of paperwork.
Remember, you have the choice of carrying these tax losses forward to another year. Don’t automatically take the deduction for the 2020 tax year, especially if your total income has taken a hit. If you’re one of the millions who lost their job because of COVID-19, the best time to use the tax credit will likely be a few years in the future.
Tax-loss harvesting can be a terrific time to get some of the dead weight out of your portfolio. Warren Buffett recently changed his mind on the airline sector and sold his entire stake in several major airlines. By doing so, he accomplished two things. First, he protected Berkshire Hathaway from further loss from these fragile industries. And he created a nice tax credit that can be used against further gains. Tax-loss harvesting focuses a lot on saving money on taxes, but let’s not forget it can also insulate you from further losses.
How to Tax-Loss Harvest?
It doesn’t have to be complicated. In fact, tax-loss harvesting is easy enough that even a relatively inexperienced investor can do it effectively. It’s just a matter of knowing what the rules are and what to expect. The process is quite simple:
- Sell your losing stock: Identify the “losers” in your portfolio and sell these stocks, making the loss official.
- Buy new stock: Buy a similar stock or ETF with the proceeds. Never buy the same one (more about that later).
- Keep a record of the transaction
An online brokerage will keep track of the transaction for you. Our top pick is Questrade because you can easily build your own portfolio at a low cost, especially since you get $50 in free trades when you sign up. We’re also fans of Wealthsimple Trade because of it offers commission-free trades. You’ll be able to buy stock and tax-loss harvest as much as you like using either of these excellent trading platforms or you can read more on the best trading platforms. Plus, you can take advantage of our exclusive promo offer: open a new Wealthsimple Trade account, and get a $50 cash bonus + $0 commission trades. All you have to do is deposit and trade at least $150.
Some robo advisors make tax-loss harvesting even easier. All Wealthsimple clients have the option of using tax-loss harvesting and it’s done automatically for Wealthsimple Black and Generation clients. All you have to do is tell Wealthsimple you want them to do it. It’s that simple.
For a more in-depth look at how to tax-loss harvest, read How Can Tax-Loss Harvesting Help Your Investment Portfolio?
The Superficial Loss Rule
Perhaps the most important rule of tax loss harvesting is to avoid posting a superficial loss. Here’s how it works:
- You can’t sell a stock and rebuy the same security again the next day. That’s a superficial loss, and it’s against Canadian tax rules. To avoid breaching the superficial loss rule, you can either buy a similar investment today or wait at least 30 days until you buy the exact same investment back again. You can’t get around this rule by having your spouse buy stock from the same company. That’ll get you in trouble with the CRA – a mistake that you actively should try to avoid.
- Selling an ETF and buying the identical ETF within 30 days is not allowed. You also can’t buy another ETF that tracks the exact same index. You are, however, allowed to purchase a similar ETF.
For example, say you owned the Vanguard Canada FTSE High-Dividend Yield ETF (TSX:VDY). That ETF tracks the FTSE Canada High Dividend Yield Index. A similar product, the iShares Canadian Select Dividend Yield ETF (TSX:XDV) tracks the Dow Jones Canada Select Dividend Index. Despite these two products having many of the same underlying stocks as top holdings, they would be different enough to qualify for tax-loss harvesting.
However, the iShares Core S&P/TSX Capped Composite Index ETF (TSX:XIC) and the BMO TSX Capped Composite IDX ETF (TSX:ZCN) do track the same index, so you couldn’t swap from one to the other to avoid the superficial loss rule.
The difference between many similar ETFs is usually quite small. They’ll share most of the same top holdings despite following different indexes. This means you’ll likely see similar performance even if you switch from one to the other.
The Last Word
Tax-loss harvesting is a little-understood strategy that can save you some serious money, especially if you have a good-sized portfolio.
The simplest way to use the strategy is to sign up with a robo advisor, like Wealthsimple, that will do it automatically for you. If you prefer to do it yourself, it’s not particularly hard to do especially if you use an online brokerage like Questrade or Wealthsimple Trade to build a portfolio with a handful of ETFs. Now is a great time to sign up because Wealthsimple Trade is offering Young and Thrifty readers an exclusive deal: get a $50 cash bonus and $0 commission trades when you open a new Wealthsimple Trade account. All you have to do is deposit and trade at least $150.
Online tax preparation software can also make all this easier. Our top choice is TurboTax because all you have to do is fill out a step-by-step online questionnaire and the software automatically finds tax-saving opportunities by searching 400+ credits and deductions. Read our TurboTax review for all the details.
With the market is still off significantly due to COVID-19 related fears, it’s a great time to implement this powerful tax savings strategy. Act now before the market rallies even more and profit from the current market downturn.
Disclaimer: Young & Thrifty has entered into a referral and advertising arrangement with Wealthsimple US, LTD and receives compensation when you open an account or for certain qualifying activity which may include clicking links. You will not be charged a fee for this referral and Wealthsimple and Young and Thrifty are not related entities. It is a requirement to disclose that we earn these fees and also provide you with the latest Wealthsimple ADV brochure so you can learn more about them before opening an account.