What is Tax-Loss Selling?

Tax-loss selling, also known as tax-loss harvesting, is a strategy available to investors who have investments that are trading below their original cost in non-registered accounts. These investments could be stocks, bonds, mutual funds and/or exchange-traded funds (ETFs). The strategy involves selling these investments and using the subsequent capital loss to offset any capital gains incurred that tax year. It's also possible to carry capital losses back into the previous three tax years and/or carry them forward indefinitely.

Sales of securities must settle within the calendar year in order to offset capital gains realized in the same year (or previous three years). Remember, settlement dates are typically two business days after a sale is initiated, so the last day to tax-loss sell will typically be at least two days before the last day of December.

What if you want to buy your stock back after selling it? Hold on, there's an important rule to keep in mind.

The Superficial Loss Rule

When you sell an investment and trigger a capital loss, the superficial loss rule states that you can't deduct the capital loss if you buy (or purchase a right to buy) an identical security within 30 days of the settlement date of your sale transaction. This means you can't purchase the security 30 days before or 30 days after your settlement date. Violating the rule means your tax benefit would effectively be cancelled. The rule also states that “affiliates" can't make a purchase.

The Canada Revenue Agency provides the following examples of affiliates:

• you and your spouse or common-law partner;
• you and a corporation that is controlled by you or your spouse or common-law partner;
• a partnership and a majority interest partner of the partnership; and
• a trust and its majority interest beneficiary (generally, a beneficiary who enjoys a majority of the trust income or capital) or one who is affiliated with such a beneficiary.

Identical Securities

Identical securities can be shares of the same company, units of the same ETF or mutual fund, or a competitor ETF or mutual fund that invests in the exact index that you just sold. To avoid breaching the superficial loss rules, investors must be careful not to purchase securities that offer identical exposure to the securities being sold.

A tax-loss selling strategy could still allow you to maintain exposure to a particular stock or sector during the 30-day period – you just couldn't buy an identical security or you would be in violation of the superficial loss rule.

Let's say an investor who sells shares of a Canadian bank at a loss later sees indicators that the Canadian banking industry may be poised to regain some ground. However, the investor cannot repurchase shares of the same bank within 30 days without invalidating the sale as a capital loss. To maintain exposure to a particular stock or sector, the investor could instead, for example, decide to purchase an ETF or mutual fund with exposure to the stock or sector of interest.

Important factors to keep in mind

When it comes to tax strategies, it is critical to remember that circumstances vary from individual to individual. While no set of guidelines applies to every investor, investors should keep the following in mind:

• Consult with a tax specialist before planning or enacting a tax-loss strategy.
• Monitor end-of-year deadlines for completing a tax-loss sale to ensure that the transaction is finalized in time to apply to the current tax year (if that is desired). Remember, settlement dates are typically two business days after a sale is initiated.
• To avoid violating the superficial loss rule, remember you can't purchase an identical security 30 days before or 30 days after your settlement date .
• Check your recent transaction history under My Portfolio to confirm your transactions over the past 30 days (and more).
• Note, any potential capital gain distributions paid by a particular ETF or mutual fund during the year may offset some, or all, capital losses harvested.
• Selling an ETF and buying into another ETF that tracks the same index within 30 days may trigger the superficial loss rule. Same applies to mutual funds.

The information provided in this article is for general purposes only and does not constitute personal financial or tax advice. Please consult with your own professional advisor to discuss your specific financial and tax needs.

A version of this article was originally published by RBC Global Asset Management.