Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.
With equity markets in volatile flux since the coronavirus pulled the rug out from under investors worldwide, you could be forgiven for becoming weary about looking at your portfolio. But there are ways to make those losses work for you.
The good news is you haven’t actually lost any money until you sell. Your losses are ‘on paper’ only. If you have the ability – in terms of immediate financial need or psychologically – to leave things alone until markets finally recover and hopefully resume a reliable upward trend, your savings plan will be back on track. History shows, through thick and thin, equity markets have produced substantial gains over the long term.
But if you have some money-losing holdings for which you hold little hope of recovery (or just want to reduce the angst of looking at them), then selling some stock may be worth it. In tax language, you would be realizing a ‘capital loss’, which, depending on your other capital transactions, can come with a silver lining come tax season.
When you sell money-losing securities, you realize a capital loss that for tax purposes that will reduce the amount of any capital gains you are reporting on your tax return for the same year. The amount of any additional loss beyond what offsets your current-year gains can be carried back to offset gains from the sale of capital assets reported in any of the three preceding years, resulting in a tax refund. Alternatively, you can “bank” any remaining 2019 loss to be carried forward to reduce capital gains realized in any future year. Remember, though, that capital losses must first be used to reduce or eliminate gains realized during the current year.
Valuing Your Losses
Consider an investment of 500 shares of a fictitious traditional department store chain that you purchased five years ago at $30 a share – a $15,000 investment. By late 2019, the price had fallen below $15 and then the pandemic hit, sending it spiralling to $6. If you decide to bail out on the stock, excluding transaction costs, your capital loss would be $20 a share, or $10,000. Put that amount to work.
While that’s a bitter pill to swallow, you’d gain some solace knowing you’d not be facing an even greater potential loss. Moreover, the loss would reduce the amount of any capital gains realized during 2020 on the sale of other capital assets. For example, you might have purchased another stock at a depressed price following the pandemic outbreak and sell it later this year at a profit.
Assuming, however, that you realize no capital gains during 2020, you could then apply that $10,000 loss to any gains you might have reported in 2019, 2018 or 2017 (or future years, 2021 and beyond) to get some of that tax cash back.
Carry Back a Loss
In line with the 50% capital-gains inclusion rate, one-half of capital losses can be used to reduce the taxable portion of a gain in another year. For example, assume you reported $12,000 in net gains on your 2018 tax return, of which $6,000 was taxable.
Assuming a 50% marginal tax rate, you paid $3,000 in capital-gains tax for that year. When you file your 2020 return early next year, you can use some of this year’s $10,000 loss to wipe out the 2018 gain and receive a retroactive refund. At a 50% marginal tax rate, you’d retrieve the $3,000 tax you paid on your 2018 return, considerably softening the blow of this year’s hefty loss.
When carrying back a loss to a previous year, you do not file an amended return for that year. Rather, complete the Canada Revenue Agency’s Form T1A, Request for Loss Carryback, which will allow you to use the 2020 net loss to reduce the capital gains you reported for one or more of the previous three years. (For Quebec tax purposes, use Revenue Quebec’s Form TP-1012.A-V.)
Carry Forward a Loss
If you earmark the 2020 net loss for use against gains in a future year, you do nothing for now, except keep a record of this amount. When reporting gains on a future year’s return, you can enter the loss (or portion thereof) when calculating that year’s net capital gains.
While you can find out the amount of total unclaimed capital losses from past years on your federal Notice of Assessment, it’s important to keep a track of each year’s net losses in order to use them to your advantage in a future, profitable year. As a long as the taxable amount of capital gains remains consistent at 50%, the process will be relatively simple. However, the inclusion rate was higher in the late 1980s and 1990s.
When capital gains taxation was introduced in 1972, the inclusion rate was 50%. It was increased to 66% for 1988 and 1989. The rate was further hiked to 75% for 1990 and remined at that level until Feb. 28, 2000, when it was reduced to 66% and then, later that year, was returned to the original 50% as of Oct. 17, 2000. The inclusion rate has since remained at 50%.
When carrying forward a capital loss from a previous year in which the inclusion rate is different from the current year, the portion of the net loss that can be used to reduce future gains must be adjusted to reflect the discrepancy. The inclusion rate in effect in the year a net loss is applied to reduce a net gain must be used. Thus only 50% of a loss reported in, say, 1998, can be used to reduce a net gain reported in a year in which the inclusion rate is 50% -- even though the inclusion rate when that loss was reported was 75%.
Note that capital losses from earlier years must be used in the chronological order of when they were reported.
What If the Inclusion Rate Increases in the Future?
The future is an unknown quantity, so it is entirely possible governments may seek ways to increase tax revenue to reduce pandemic-inflamed deficits. Will changes in marginal tax rates and brackets remain in line with inflation? Will the tax treatment of the various types of investment income stay the same? Or might Ottawa and the provinces hike tax rates or, more specifically, increase the capital-gains inclusion rate, which would cut more heavily into investment profits. This is not without precedent; in 1988, the inclusion rate was increased to 66% from the 50% that had been in pace since capital gains tax was instituted in 1972. Two years later, it was further hiked to 75% and remained at that level until 2000, when the rate was cut to 66% and then to 50%.
Given that governments will want to encourage a revival of equity markets, increasing capital-gains taxation seems unlikely in the near term. But investment profits have long been eyed by fiscally challenged governments as a source of increased tax revenue, so the prospect is nonetheless worth keeping in mind. However, in the case of using 2020 a net loss to reduce gains in a future year in which the inclusion rate might be higher, at least you would be able to apply a higher percentage of that loss against such gains.
For more information on applying capital losses to other taxation years, see the CRA’s Capital Gains Guide (T4037) and Revenue Quebec’s Capital Gains and Losses Guide (IN-120-V).
