Understanding capital gains and tax-loss selling

While we typically want investments to increase in value, there can be a silver lining to selling investments at a loss. With the right timing and strategy, you may be able to apply investment losses against taxable capital gains – a technique known as tax-loss selling or tax-loss harvesting. When following the rules, selling underperforming investments in your non-registered accounts could help reduce tax on capital gains and potentially boost your after-tax investment returns. Tax-loss selling is a tax strategy not an investment strategy, therefore investment objectives and your long-term goals should take priority. 

What are capital gains?

Capital gains represent the increase in the value of an investment such as a stock, mutual fund, exchange-traded fund (ETF), real estate, or other asset. The gain is calculated as the difference between the proceeds from the sale and your adjusted cost base (the difference between the total original purchase price of a security plus reasonable expenses to acquire it such as commissions and reasonable costs of disposition). 

While a capital gain reflects the increase in the value of the investment, a realized capital gain occurs when the investment is sold for more than its adjusted cost base (ACB), thereby locking in the profit. 

What are capital losses? 

Capital losses represent the decrease in the value of an investment such as a stock, mutual fund, ETF or real estate while realized capital loss occurs when the investment is sold at that lower value locking in the loss. 

How is tax applied to capital gains and losses?

Net capital gains or losses represent the overall result after adding together all realized gains and subtracting all realized capital losses each year. Net capital gains or losses are generally only taxable in non-registered accounts such as individual or joint investment accounts and non-principal residences. For example, if you realized $20,000 in capital gains and $10,000 in capital losses in any one year, your net capital gain is $10,000. Capital losses cannot be used to offset earned income. Capital losses realized in registered plans such as Registered Retirement Savings Plans (RRSPs), Registered Retirement Income Funds (RRIFs), First Home Savings Accounts (FHSA) or Tax-Free Savings Account (TFSAs) cannot be used to offset taxable capital gains. 

Fifty percent of the net capital gain is taxed at your marginal tax rate. Going back to the previous example, if your net capital gain is $10,000, $5,000 would be taxed at your marginal tax rate. 

What is tax-loss selling?

Tax-loss selling is a strategy employed to reduce your net capital gain; thereby reducing the amount of tax you're subject to on realized gains. This is achieved by selling investments at a loss to offset some or all the tax you pay on the realized gain. Assets that have decreased in value can be sold to reclaim capital gains tax paid in the previous three calendar years, or the losses can be carried forward to offset tax on future capital gains, indefinitely. To carry back a capital loss, complete a Form T1A – Request for Loss Carryback for the years in which you want the loss applied. Speak with your tax professional for additional details. 

Who should consider tax-loss selling?

You may want to consider tax-loss selling if you have unrealized losses in a non-registered account and paid tax on gains in the past three calendar years or anticipate having taxable gains this year or in the future. To be effective, the strategy should result in an overall tax savings after accounting for all related transaction costs, including commissions and any potential lost opportunity from selling a particular investment. The higher your marginal tax rate, the greater the tax savings. 

When should you consider tax-loss selling?

Tax-loss selling can be done at any time, allowing you to take advantage of periods of market volatility. Keep in mind that if you're trying to limit tax-loss selling to near-term gains, you may not have a good sense of your expected gains until closer to the end of the year for certain investments, such as mutual funds. 

Applying the losses

The Canada Revenue Agency (CRA) outlines the rules that guide the use of tax-loss selling. Generally, any losses realized in the current year must be used to offset gains triggered in the same year first. Any net capital losses remaining can then be applied against capital gains in the previous three years or any future year. For example, if you have a $10,000 realized capital loss and a $4,000 realized capital gain in the current year, the loss must first be applied to the gain realized this year, and the resulting net realized loss of $6,000 can then be applied to realized gains in the previous 3 years or carried forward indefinitely. You cannot elect to pay taxes on the $4,000 gain and carry the full $10,000 loss forward to future years. 

Risks associate with tax-loss selling 

While the objective of tax-loss selling is to offset realized capital gains with realized capital losses, there could be risks associated with the strategy, that may reduce the benefit or make the strategy disallowable. Risks include:

• Transaction costs, such as commissions, associated with selling, and re-purchasing investments.
• Time out of the market could result in missing out on income or dividends from the investment.
• Market volatility could result in repurchasing assets at a higher value.
• Selling assets at a loss could result in unintended changes to your investment allocation. 

Superficial losses

The CRA limits superficial losses and re-purchases by affiliated persons. Superficial losses occur when you dispose of capital property, and then you or a person affiliated with you, buys the same or remarkably identical property 30 calendar days before or after the sale. 

Affiliated persons 

Affiliated persons include:

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

How to effectively execute tax-loss selling

When it comes to tax-loss selling, it is most effective to focus on investments you want to dispose of or reduce exposure to. It can be a great way to rebalance your portfolio at the same time as you sell those investments that have decreased in value. If you want to own a similar security to the one that you're selling, replace it with a similar investment that will satisfy the superficial loss rules. 

We can help

If you have questions about tax loss selling, speak with a tax professional and an Edward Jones financial advisor who can help you with strategies to minimize tax.