The Canada Revenue Agency is not known for giving taxpayers a break. The tax treatment of failed investments is a welcome exception. If an investor loses money when she sells capital property such as a stock, bond, exchange-traded or mutual fund or real estate, she can subtract the losses from her capital gains before calculating the tax owed.
There are numerous rules to follow in order to benefit from this tax break. Prudent recordkeeping and careful planning well in advance of the calendar year-end are crucial for optimizing your tax savings.
The first thing to note is that this tax treatment applies only to capital losses in non-registered accounts. If you have losing investments in your RRSP or tax-free saving account (TFSA), consider revamping your portfolio to hold riskier investments in a non-registered account, so you can take advantage of this tax break in the future.
The capital gain or loss arising from selling an investment is calculated using the following formula:
Capital gain/loss = Net sales proceeds minus Adjusted cost base.
Net sales proceeds equal the amount received from selling an investment, minus selling expenses such as brokerage commissions and mutual-fund redemption fees.
You can determine the adjusted cost base (ACB) by adding up the investment purchase price, buying expenses and any reinvested distributions/dividends, and subtracting any return of capital distributions and the ACB of any previously sold units or shares. If you hold the same security in more than one non-registered account, the ACB is based on the purchases in all accounts.
You can find the data for calculating actual capital gains or losses on your original sales-transaction slips and the account statements which cover the transaction dates. Most brokers will provide a summary of capital gains and losses shortly after year-end. Consult your financial adviser if you need help locating the relevant numbers.
To estimate the capital gain or loss that would result from selling an investment, subtract the investment's book value from the market value, as shown on your most recent account statement.
Capital losses occurring in a particular year must first be applied against capital gains made in the same year, but any excess can be carried forward indefinitely. A net capital loss in one year can be used to offset taxable capital gains in any of the three preceding years.
Investors must take care to avoid booking what CRA terms superficial losses, since these do not qualify to offset capital gains. A loss is superficial if you or someone affiliated with you such as your spouse buys (or has a right to buy) the same or an identical property during the 30 days before or after the sale that triggered the loss.
The tricky part is CRA's interpretation of identical property. According to the CRA bulletin on the subject, "identical properties are the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another."
Hence, for example, a loss from selling iShares Core S&P 500 Index ETF XUS might be considered superficial if you bought the very similar BMO S&P 500 Index ETF ZSP within the aforementioned 61-day window.
Should you sell unprofitable investments before year-end to reduce taxes? "Tax savings should never be the principal reason to sell an investment," says Dennis Tew, chief financial officer for Franklin Templeton Investments in Canada. "Your investment strategy is first and foremost when considering tax-loss selling."
Testing various selling scenarios against your investment plan is the key to determining which investments you should sell before year-end. There is much to consider.
- What capital gains have you already booked this year? What about capital losses?
- Does your current portfolio match its target asset allocation? If not, what investments could be sold to rebalance? Which ones should be sold for the best tax outcome?
- Which investments exceed your size limit for an individual holding? What capital gains or losses would result from selling off the excess?
- Are there any investments with poor future prospects? If you sold them, what gains or losses would you realize?
- Do you anticipate any year-end capital-gains distributions from exchange-traded funds or mutual funds? The final numbers will be available only after the year-end, but a fund's distribution policy and history can provide an estimate. In early December, mutual-fund and ETF companies post estimates of expected distributions on their websites.
- Did you report net capital gains in any of the three previous tax years? Capital loss carryforward/carryback information is listed on past CRA notices of assessment and is also available by logging into your CRA online account.
- Do you have capital losses this year that you want to apply against gains from the past three years? If so, you will need to complete and file CRA Form T1A Request for Loss Carryback.
- Do you have any capital losses from previous years that could offset this year's gains?
After settling on the tax-loss selling actions that best fit your investment plan, act promptly. If you wait until December, other investors may be scrambling to sell the same losers before year-end, possibly depressing the selling price and exacerbating your loss.
