Investors may be experiencing portfolio declines this year due to numerous market issues including out-of-control inflation and rising interest rates. With that in mind, if an investor sees red on their investment statements, there may be an opportunity to purposely take a loss to reduce taxation. Before proceeding, this concept needs to be properly understood to ensure that the strategy can create a benefit.
The most key factor in deciding to take a capital loss for tax purposes is understanding the type of account where the loss is held. Specifically, a capital loss can only be used for tax purposes if it occurs in a non-registered account. This means that losses in accounts such as the Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) have no taxable advantage as the topic pertains for this article.
Simply put, a capital loss occurs when an investor has disposed of a security for a lower price than what it was originally acquired for. This capital loss can only be used to offset capital gains from the previous three years, or anytime in the future. Therefore, capital losses can not be used to lower your employment income, or interest from bonds and guaranteed investment certificates (GICs), or even dividend income. Specifically, to benefit from a capital loss you must also have a capital gain.
How this strategy may work, is to purposely sell an investment in a loss position in a non-registered account. The thinking is that an investor can then use this loss to apply against a previous gain that was claimed and had taxes paid on. If no previous gain exists, an investor could carry-forward this loss to a future year.
In most scenarios, investors do not want to be completely out of the market, even if the tax strategy of purposely creating a loss might make sense to them. Therefore, the next step of this strategy is that once the investment is sold for a loss, another new investment is made immediately in a different security. It can be an investment in a similar sector or a similar strategy, so long as it is not deemed to be the same security. The benefit here is that an investor has created a capital loss to use this year or in the future, while immediately reinvesting their proceeds for future gains.
An investor may even choose to reinvest back to the same security so long as it is not done within 30-days of the sell. If done prior, this is referred to as a superficial loss and the capital loss would be nullified for tax purposes. To avoid this scenario, investors can sell their original investment, buy a different security, and then after 30-days sell this security and buy back the original. The point being is that the dollars stay invested over that time, while the investor is still able to use the loss for tax purposes.
An example of this, is selling a technology stock in a loss position, while immediately buying a different technology stock. The investor continues to hold shares of the new technology stock for a minimum of 30-days. After this period has passed, the investor chooses to sell shares of the new company and replace them with shares of the company they owned before. Assuming this was done in a non-registered account, the loss is triggered and can be used to offset a gain in the last three years, or a future gain as the shares possibly recover.
While no investor wants to see a loss in their account, there are times when using losses can be an effective way to help mitigate tax. With that in mind, it is imperative that this strategy is reviewed with a qualified Wealth Advisor and a tax specialist before proceeding.
Also, we’d like to point out an oversight error in the last issue of Wealth Watch that addressed TFSAs. Specifically, when it was written “Although they’ve deposited $81,500, they receive no tax slip for this deposit and as such can use that deposit to decrease their taxable income” – it should have read: “CAN NOT use that deposit to decrease taxable income”. Specifically, TFSA deposits do not decrease taxable income.
Derek Fuchs is a Senior Wealth Advisor and Portfolio Manager with Scotia Wealth Management based in Red Deer. He writes this column to help educate and inform local investors. Have a question? Email Derek at email@example.com anytime.