Traditional equity index funds are often touted for the tax-efficiency of their structure, and rightly so. But there’s another potential tax advantage that few ETF investors employ. Justin Bender and I explain the details in our brand new white paper, Tax Loss Selling: Using Canadian-listed ETFs to defer taxes on capital gains.
Tax loss selling is a technique for harvesting capital losses in non-registered accounts so they can be used to offset capital gains incurred elsewhere. Suppose you hold $50,000 worth of a Canadian equity ETF and its value declines to $45,000. By selling your shares, you can crystallize a capital loss of $5,000. And by claiming that loss, you may be able to offset a $5,000 capital gain elsewhere in your portfolio, potentially deferring hundreds of dollars in taxes.
When you file your tax return, any capital losses must first be used to offset gains you’ve incurred in the current tax year. Any remaining losses can be carried back up to three years, or carried forward indefinitely to offset future capital gains. (To carry back current capital losses to prior years, you need to file form T1A – Request For Loss Carryback with your return.)
The problem with realizing a capital loss is that it can mean selling a security that plays an important role in your portfolio. Investors who buy individual stocks have limited opportunity for tax loss selling: if your holding in Royal Bank has declined in value and you sell it to capture the capital loss, you could miss a big upward move in that stock. And you can’t simply buy back more Royal Bank shares and continue to hold them: if you do, the Canada Revenue Agency (CRA) will declare your claim a superficial loss and you won’t be able to use it to offset gains. (The superficial loss rules are actually quite complicated: full details are in the white paper.)
Sell low, buy low
ETF investors have an advantage over those who buy individual stocks. They can systematically harvest capital losses while maintaining constant exposure to all the asset classes in their portfolio—all while staying within the rules set by CRA. The key idea is simple: after selling one ETF that has declined in value, you immediately purchase another ETF in the same asset class. That way you can realize a capital loss and still maintain similar diversification.
But there is an extremely important idea you need to understand first. In order to avoid the superficial loss rule, the replacement ETF must not be considered identical property to the one you sold. This doesn’t just mean you can’t sell the BMO S&P/TSX Capped Composite (ZCN) and then buy it right back. It also means you can’t sell ZCN and replace it with the iShares S&P/TSX Capped Composite (XIC).
This is because in 2001 the CRA issued a bulletin (TI 2001-008038) stating that two index funds tracking the same benchmark are considered identical property. According to this interpretation, if you claim a capital loss after selling ZCN and buying XIC (or vice-versa) it would be considered a superficial loss. The same holds for replacing the BMO MSCI Emerging Markets (ZEM) with the iShares MSCI Emerging Markets (XEM), or the Vanguard S&P 500 (VFV) with one of many other funds tracking that index.
However, after a bounty of new Canadian ETFs was launched this year, it’s easier than ever to swap ETFs that are similar, but track different indexes. That would allow you to maintain virtually the same market exposure while harvesting capital losses and staying within CRA’s rules about identical property. Later this week we’ll look at some specific suggestions for Canadian, U.S., international and emerging markets.
The information in this post should in no way be considered tax advice for individuals. The rules around tax-loss selling are complicated and subject to interpretation. Always consult a qualified adviser before making any transaction for tax purposes.