Taking Advantage of a Loser: Tax Loss Selling
An Introduction to Tax Planning – Part 2
“Oh, man! What is this guy talking about? He’s calling people losers and then he is suggesting a way to take advantage of them!” Let me explain. First of all, I am not calling *people* losers. Second, this is a post about taxation, not about predatory business practices seeking unethical advantages.
The reality is that sometimes we buy into investments that lose money. For example, imagine you had bought 100 shares of UE Bank (a fictionalized name) at its 52-week high of $77.96 on July 5 last year. That is a $7,796 cost to you. As you may know, stocks started tumbling last week. UE Bank was hit fairly hard. As I write this, its lowest trade so far has been at $67.69. You can no longer tolerate the continuing losses, so you decided to sell your 100 shares. You received $6,769 for a capital loss of $1,027 ($6,769 – $7,796). That’s a bitter pill to swallow to be sure. You do some research, though and buy a different investment with your $6,769. Amazingly, that stock does quite well. When it reaches $8,000 in value, though, you sell it in December of this year for a capital gain of $1,231 ($8,000 – $6,769).
What is Capital?
At its simplest, capital is property. Rather than stocks, for example, if you buy a rental property for $500,000 and hold it for several years collecting rent from your tenants over that time, that property is a type of capital. I will stick with securities – stocks, mutual funds, etc. – for this example, though. Let’s suppose that you had invested $500,000 in a diversified investment portfolio.
What is a Capital Gain?
Suppose you held that investment portfolio for 10 years and then decided to sell it all. You are 70 years old. You have retired. You want to buy an annuity that will pay you a guaranteed amount of money each month for the rest of your life. The assets in the portfolio have grown over the years to the point that, when you sell them all, you get $1,000,000. The difference between what you sold your investments for for and what you paid for them, $500,000, is a capital gain.
What is a Capital Loss?
Suppose you held a similar investment portfolio. You had regularly contributed new money and reinvested all your dividend and interest payments over the years. The portfolio was worth $1,000,000 and your cost – the Adjusted Cost Base – after taking into account all the periodic investments, was $750,000. You were content to keep on holding, but at age 55 a series of unfortunate events strikes. You get in a car accident and are no longer able to work. You were self-employed in a physically demanding job but did not have disability insurance. You have to retrofit your house to accommodate your new physical limitations. As a small solace, you are eligible for the CPP Disability Benefit. You have nowhere else to get additional income, however, than your investment portfolio, so you start to sell off your investments. Just when you begin to sell off parts of your portfolio to supplement your income, a recession comes along and your investments start to lose their value. Eventually, the economy stabilizes and your investments recover, but the sales you had to make to cover your living expenses resulted in a capital loss of $100,000, permanently impairing how much you can draw from your investment portfolio in future years.
How do I Take Advantage of Capital Losses?
While the above scenarios are certainly possible, they usually aren’t quite so black and white. A more common scenario might be a situation where you own a portfolio with multiple investments in it. In a given year, some do well, and others do poorly. Imagine that a year ago you had $150,000 and bought the shares of 15 different companies for $10,000 each. The stock of company ABC did really well, gaining 145% in the year. The stocks of companies DEF, GHI, and JKL, unfortunately, lost 25%, 20% and 19%, respectively in that same year. You decide to sell all four of those positions.
This is fairly straightforward addition and subtraction. ABC stock provided a capital gain of $14,500 and the three other stocks lost a total of $6,400. The result is a net capital gain of $8,100, which will mean that you will pay less tax than if you had only sold ABC stock with it’s $14,500 gain.
The Advantage of Capital Gains
Capital gains are riskier that interest or dividend payments. Those get paid into your account as cash and while you do have to pay tax on them in a non-registered account, that is actual money in your account. Capital gains remain “unrealized” until you sell the investment. To encourage the risk-taking that is involved in investments, the government has set a tax policy that taxes capital gains at only 50 percent of the level of interest income. If you received $1,000 in interest income in 2019 and you were in a 30 percent tax bracket, you would pay $300 in income tax. If that same $1,000 came to you as the result of a sale of an investment for a capital gain, you would only pay $150 in income tax.
What is the Adjusted Cost Base (ACB)?
The Adjusted Cost Base (ACB) could simply be your cost to buy an investment. If you buy 100 shares at $100 per share and do not pay any fees for the transaction, then your ACB is also your cost of $10,000. But it could be something different, too. If you paid a commission at the time of the sale, that would adjust the cost. If the stock paid dividends and you arranged with your broker to have those dividends reinvested, that would also adjust your cost.
In the above table, I show an initial stock purchase of 1000 shares at $10 per share for $10,000 plus a commission charge of $10. That results in an ACB or Adjusted Cost Base of $10,010 or $10.01 per share. Quarterly dividends are $0.10 per share. On 1,000 shares that means the dividend is $100 each quarter. At the time the dividend is paid out and the stock is reinvested, however, the price of the stock has risen to $11.11 so only 9 shares can be purchased as shown in the Qty (Quantity) column. It is typically the case that you can only buy whole shares via a stock brokerage. The leftover penny in this case sits as uninvested cash in the account. The account now holds 1009 shares and the $99.99 cost is added to the ACB for the position. The next row repeats with another dividend reinvestment, followed by a new purchase of 750 shares and then two more dividend reinvestment transactions.
If, at the end of the year, you were to sell all 1789 shares for $17 per share, the following would be the calculation you would make:
After deducting the $10 commission from the proceeds of $30,413 you are left with net proceeds of $30,403. Based on your ACB of $20,600.67 your capital gain works out to $9,802.33 or $5.47 per share.
What would happen if instead you sold your 1789 shares for $11.00 per share? Why would you do that? Well, just a month before it was trading at over $16 per share. Maybe you decided to cut your losses out of fear that it would continue to decline.
The consequence is a capital loss of $931.67 or $0.53 per share.
Beware of Superficial Losses
Let’s imagine the last scenario above occurred. You sold your shares for a loss of $931.67 because the stock was falling. However, a week later the stock hits bottom at $10.50 and starts turning around. Two weeks later, it’s at $12.00 and looks like it’s going to continue to climb. So, you buy back in three weeks after you sold the stock, on January 12, 2021.
A problem arises when you buy the same stock within 30 days of having sold it at a loss. That is called a superficial loss and the CRA will deny your claim of a loss. What will happen though is that your capital loss will be added onto your new purchase, adjusting your ACB upward by that amount.
Later, when you eventually sell the position, as long as you avoid the Superficial Loss rule you will effectively be able to claim your capital loss because the amount of gain if sold at a profit will be reduced by $931.67, or if again sold at a loss, the loss will be increased by $931.67 because you are now working from a higher ACB.
In Which Account Types Can I Use Capital Losses to Offset Gains?
As you may be aware, the only accounts in which the tax implications of your investment income apply are non-registered accounts, so-called cash accounts or margin accounts, to be specific. Money invested in a tax-deferred registered account like an RRSP only has tax applied to it when the money is withdrawn. As long as the asset inside the RRSP is a qualified investment, the manner in which the account grew, whether through contributions, interest, dividends or capital gains, is irrelevant to the CRA. Investments are sheltered from tax while inside the RRSP. Similarly, investments in a TFSA are sheltered from tax while they are in the account and at the time of withdrawal. That is a benefit when you have income from interest, dividends or capital gains. It is of no benefit, however, if you have capital losses since losses cannot be used to offset gains.
What are the implications of this? You may want to consider investing in riskier assets that are focused on capital growth inside of non-registered accounts so that, if your risk turns out to not have been rewarded, you can sell the losing position and claim a capital loss.
Carrying Your Losses Backward and Forward
If you have a capital loss in a given year but are unable to use it fully in the year of the loss, you can carry back that loss up to three years, or you can carry the capital loss forward indefinitely to apply against future capital gains.
My next post will touch on income-splitting and attribution rules.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.