Tax-loss selling

Whenever capital property is sold, a gain or loss is incurred. Normally, we want a capital gain to occur because that means we made money on our investment. However, the downside of a gain is taxes. Everyone needs to pay taxes on capital gains (unless the gain occurs inside of a tax-sheltered account like a TFSA). In this guide, you’ll learn how to reduce your taxes through tax-loss selling.

What is tax-loss selling?

Tax-loss selling, also known as tax-loss harvesting, is a strategy used to reduce taxes on capital gains incurred from the sale of an asset. In Canada, 50% of capital gains are taxable. However, capital losses can be applied against capital gains to reduce the gain amount in order to lower the taxes owed.

Tax-loss harvesting involves selling an investment that is known to have incurred a loss. Then, the loss from that sale is put against the capital gain, which reduces your tax liability.

In general, incurring a capital gain on the sale of an asset is a good thing. We all want to earn money on our investments. However, there are tax consequences of making gains, which is where tax-loss harvesting comes into play. Tax-loss selling is a strategy used on stock, ETF and other similar investments, but it can be used for other purposes too.

What are capital gains?

When you sell an asset, such as a stock, car or piece of art, you’ll receive a certain amount of money known as the sale price. A capital gain arises when the sale price is greater than the original cost of acquiring the asset.

How are capital gains taxed?

In Canada, 50% of the value of capital gains are taxable. If you have a capital gain, 50% of its value must be reported as income on your tax return in the year the asset was sold. However, capital losses can be applied against capital gains to reduce the total tax liability.

For example, let’s say Joe purchased a piece of art in 2010 for $100. In the same year, Joe also purchased a car for $3,000. In 2021, Joe sold the art for $10,000 and sold the car for $1,000. Let’s take a look at the capital gain and loss calculation below.

Joe would be required to report $3,950 ($4,950 – $1,000) as income on his tax return in the capital gains section. The amount of tax Joe pays depends on his tax bracket and the province or territory he resides in.

What are the benefits of tax-loss selling?

• Reduced tax bill. Tax-loss harvesting reduces the total amount of tax you owe on a capital gain.
• Short- and long-term uses. Tax-loss harvesting can be used for both short-term (held less than a year) and long-term (held longer than a year) investments.
• Portfolio rebalancing. Tax-loss selling allows investors to rebalance their portfolios. This means eliminating high capital gains and losses.

Note that the process of selling capital property to trigger a loss is completely legal and accepted by the CRA.

Tax-loss selling: When should you do it?

The best time to participate in tax-loss harvesting is the end of December, specifically the last 2 weeks. If you know of a capital gain from earlier in the year or want to trigger a capital gain, you can utilize tax-loss selling strategies at the end of the year. The final 2 weeks of December are prime days because it’s enough time to trigger a capital loss and allow the transaction to settle before December 31.

Tax-loss selling: How do you do it?

First, you must have a capital gain. A capital gain may have been incurred earlier in the year or you can trigger one by selling capital property that has appreciated.

Once you have a capital gain, it’s time to trigger a capital loss through tax-loss harvesting. Simply identify an asset that has depreciated. Sell the asset and record the amount of the capital loss to be applied against the capital gain.

It’s best if the loss you trigger consumes most or all of the capital gain, but does not create an excess loss. The CRA does not reimburse you for excess losses. Instead, they can be carried forward or backwards to other tax years. The process of carrying forward or backward capital losses can be complex. It’s best if you use all of the losses in the year you incurred them.

Once the year is over, you can report the capital gains and losses on your income tax return. From there, you will have to pay tax on the net amount. The smaller the net amount, the less taxable income you have that year. The amount of tax you pay depends on your tax bracket and the province or territory you live in.

Documentation

To report capital gains and losses on your tax return, you will need certain documentation. Normally, this is a receipt for the capital property when you originally purchased it and sold it. This proves the purchase price and the sale price.

As a part of submitting your tax return, you do not need to submit original copies of receipts. However, if you’re audited by the CRA, they may ask for proof of the purchase and sale. If you cannot produce these documents, there could be tax consequences. As a general rule, keep a record of all your capital property purchases and sales for at least 4 years.

What to watch out for when tax-loss harvesting

• Superficial-loss rule. A superficial loss occurs when you sell capital property to trigger a loss then purchase the same capital property within 30 days of the sale date. The CRA does not allow superficial losses to be reported as capital losses. The only exception to this rule is when you re-purchase assets that are similar to the capital property you sold.
• Accepting a capital loss. If you’re holding capital property that is worth less than what you bought it for, that’s an ideal asset to sell for tax-loss harvesting. However, the asset may realize a gain over time. By selling it now, you are realizing your loss and forgoing any potential gain in the future.
• Taxes aren’t everything. Incurring a gain on an asset is a good thing. It means you made a wise investment. No one likes paying taxes on the money they make, but this is part of investing.

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Bottom line

Tax-loss selling may sound like a complicated process, but it doesn’t have to be. Applying your losses to your gains can be a smart way to lower your taxable income. However, it isn’t necessary to sell assets to trigger a loss if this doesn’t align with your goals.

Frequently asked questions

• When do I report capital gains and losses on my tax return?

  In Canada, the taxation year is from January 1 to December 31. In the year you incur a capital gain and/or loss, you must report it on your tax return. Most commonly, tax-loss harvesting occurs in the last 2 weeks of the taxation year as a tax preparation tactic. This gives enough time for the transaction to settle before December 31.

• What's the difference between capital and non-capital losses?

  Capital losses can only be applied against capital gains income. Capital losses cannot be applied against other income, such as employment or business income.

  Non-capital losses occur when a taxpayer incurs a loss other than a capital loss. Normally, a non-capital loss arises from employment or business. For example, if you own a small business and incurred more expenses than income, you would have incurred a business loss. Non-capital losses can be applied to all forms of income.

• How do loss carryforwards and carrybacks work?

  Tax law says that capital losses must be applied against capital gains. A capital loss cannot be reported unless there is a capital gain. In this case, capital losses can be carried forward indefinitely or carried backwards for 3 years. This means if you had capital gains income in the future or in the past 3 years, you can apply your remaining capital loss against it.

• Are there any tax-loss selling rules?

  The only tax-loss selling rules in place are the superficial-loss rule and the year-end cut-off dates. The superficial-loss rule says you can’t trigger a loss through an asset sale then purchase the same asset within 30 days of the sale date. The year-end cut-off means the capital losses must have occurred between January 1 and December 31 of the taxation year in question. If the tax loss occurred after December 31, it must be incurred in the following year.