Take advantage of tax losses before year-end

The art and science of tax-loss selling

We are officially in a bear market, which means that we are in an extended period of prolonged price declines. From what I have read, stocks lose 36% on average in a bear market. Now, if your investments are in an RRSP and you are still relatively young, you can afford to ride this out. But others may want to consider whether 2022 is the year to trigger some losses to shelter gains, especially if you have had gains earlier this year, or in the past three years.

This is not any sort of investment advice. You should leave that to your financial advisers and portfolio managers. But from a purely tax perspective, if you have had some larger gains, and are looking to offset this, then perhaps you may want to consider speaking to your investment advisor about whether there are any losses that you should just take before year-end in order to claim a loss on your 2022 tax return.

This strategy is known as “tax-loss selling.” It refers to triggering losses before December 31 to offset capital gains that you may be facing for 2022 or to offset any gains in the previous three tax years (capital losses can be carried back three years). So, while you may not be making much money from these “loser investments,” the loss that results can be used to offset any gains you might have had, which at the end of the day translates into lowering your tax bill and more dollars into your pockets. Sounds easy doesn’t it? But before you place your sell order, here are some other things to watch for.

Do you need a tax loss?

If you don’t have any capital gains for 2022 or going as far back as 2019, there’s no need to run out and sell a loser just for its tax loss. That’s because capital losses can be used only against capital gains. For most investors, the result will be a capital loss. A capital loss cannot shelter income from your job, a business, or even an employee stock option benefit. So if you have no capital gains, then there’s no point in tax-loss selling. (A possible exception applies to losing investments in Canadian private corporations devoted to active-business endeavours – this could include over-the-counter traded stocks.)

Do you have a tax loss?

You probably are thinking that it’s a good likelihood that you are sitting on at least a couple of losses. However, don’t assume this is the case. The first question to ask yourself is whether you actually have a tax loss to begin with. This depends on the tax cost of your investment – or as we tax drones call it, your “adjusted cost base.” One important thing to bear in mind is that you must calculate your tax cost on a weighted average basis for all identical investments.

Let’s say that you bought 2,000 shares of Xco at $20 per share and another block of 1,000 shares of Xco at $40. Suppose that you also decided to take your lumps on the second purchase and you sold the block of 1,000 at $30. Your loss would be $10 a share, right? Wrong! You have to calculate your cost on the weighted average basis. Since most of your shares were bought when the stock was below its selling price, the weighted average cost per share would be $36.67, that is (2,000 x $20 + 1,000 x $40)/3,000, so that apparent $10 loss would turn into a $3.33 gain per share. You must use this approach even if you used a different broker for each purchase.

Happily, though, initial purchases by other family members will not figure in the weighted-average calculation. For this reason, it may make sense to have other family member make the initial purchases, in order to “isolate” cost base in each person. In the previous example, if your spouse had purchase the second block at $40 and had sold it, your spouse’s adjusted cost base would have been based on the $40 amount.

Advanced tax loss strategies

The kiddie double play. One way to trigger losses is to transfer shares to your kids. In fact, if you play your cards right, you could end up getting a tax-reducing “double play.” First, you get the tax loss itself from the flip. But in addition, once your kids own the investment, future capital gains can be taxable in the child’s hands – often resulting in little or no tax because they would likely be in the lowest (or lower) tax bracket. In other words, you get to claim the tax loss, and when the investment recovers in value, the capital gain could be much cheaper than if it were held in your hands, and perhaps even tax-free.

Here’s how it works: Every Canadian individual – irrespective of age – is legally entitled to the basic personal exemption, which covers off the first $14,398 of income (federally, for 2022). And with the 50% capital gains inclusion rate, this means that kids can now earn over $28,000 of capital gains annually without paying a cent of tax at the federal level.

After your kids run out of personal exemptions and the like, they are taxed at the lowest tax bracket (assuming they have no other income). You’re also entitled to claim a corresponding provincial basic personal amount, which will vary depending on which province you live in (Ontario’s amount is $11,141 for 2022). Note: Your loss can’t be used to shelter your child’s gain.

In the case of minors, remember that the strategy applies only to capital gains. If dividends or interest are paid after the flip, the general rule is that you must pay tax on this income until the year in which the child turns 18 (due to the attribution rules). To make the transaction legal in the eyes of the tax department, make sure the investment is transferred to a separate account for the child.

It’s a good idea to have a written agreement to back up the flip – especially if your broker insists that the transfer be made to a socalled “in-trust account,” which is registered in the name of an adult. The paper should document that there has been a transfer of ownership either by way of gift or sale.

Beware the superficial loss rules!

The superficial loss rules can veto a capital loss if you’re selling on the market to take a loss, and you buy back an identical investment within 30 days before or after the sale. Although these rules are designed to counter artificial losses, they could apply inadvertently – for example, if you sell, then change your mind and buy in again, maybe after the stock has dropped further. The rules will also apply if your spouse buys back in within the 30-day period (or a controlled company), but not if a child or parent reinvests. The rules apply not only to stocks, but to mutual funds as well. But they only apply if you repurchase an identical asset. So if you sell Bank A and buy Bank B, you’re okay.

Mutual satisfaction

If your mutual fund is down, one way to trigger a tax loss is to convert to another fund within the fund familym, e.g., from a Canadian equity to a U.S. equity or money market fund. (Note: tax losses can’t be claimed if the investment is in your RRSP.) However, some funds have been set up so that when this conversion takes place, there is no gain or loss recognized for tax purposes (of course, the idea behind this type of structure is to defer capital gains). This should be checked out before you make the conversion.

Settle in

Remember that for open-market trades, the date of the tax loss is the settlement date, not when you tell your broker to sell. On Canadian stock exchanges at least, this is three business days after the trade date. Therefore, in order to claim a tax loss in 2022, the trade must actually “settle” by December 31, 2022.

So if you are thinking of waiting to trigger that loss until late in the calendar year, to be sure that you don’t miss the last possible “settlement date” (what with all the holidays at the end of December), you should check with your broker. (Different rules may apply in the U.S.; and if the transaction is a “cash sale” – payment made and security documents delivered on the trade date – you may have until later in the month.)

Watch foreign currencies

When assessing whether you’re in a loss position, don’t forget that capital gains are calculated in Canadian dollars – so currency fluctuations can be a key consideration. If the Canadian dollar has appreciated against the currency, there will tend to be losses.

Defer your loss until next year

One example of when you may wish to pass up claiming a loss carryback is if you were in a lower tax bracket in earlier years than you expect to be in the near future, and you expect to have capital gains going forward. Although capital losses can be carried forward indefinitely – i.e., to be applied against future capital gains – the farther into the future your capital gain is, the lower the “present value” of your capital loss carry forward. If capital gains are a long way off, it might be better to apply for a carryback and get the benefit of a tax refund now – even if you were in a relatively low tax bracket.

On the flip side, if you intend to sell off an investment for a capital gain around year end (assuming this downward market hasn’t affected all of your investments), you may want to defer the gain to 2023, because you can postpone the capital gains tax for a year. Note: You don’t have to actually wait until the new year to do this, as long as you sell after the year-end settlement deadline (again, check with your broker to ensure you have the correct settlement date). One exception to this strategy is if you expect to move into a higher tax bracket next year.

Samantha Prasad, LL.B., is a Partner with Toronto law firm Minden Gross LLP, a Meritas Law Firm Worldwide affiliate, and specializes in corporate, estate, and international tax planning. She writes frequently on tax issues, and is the co-author of Tax and Family Business Succession Planning, 3^rd Edition. She is also co-editor of various Wolters Kluwer Ltd. tax publications. A version of this article first appeared in The TaxLetter, © 2022 by MPL Communications Ltd. Used with permission.

Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.