Thursday, 10 December 2009

Tax Loss Selling Explained: What, Why and How

Tax loss selling is a strategy often recommended to investors but seldom explained. Let's explore how and why can investors benefit.

What is Tax Loss Selling?
It is the sale of investments whose value has dropped below their original cost in a taxable non-registered account. The purpose is to realize a capital loss in order to offset a capital gain. The loss must be applied first against current year gains and after those have been wiped out, the investor may apply the loss against gains within the past three years, (gains further back are not eligible, which is the reason for meeting the 2009 deadline so that possible 2006 offsets are not lost), or may carry it forward indefinitely. Income taxes paid on capital gains in prior years will be refunded to the investor upon filing the proper forms. The capital loss only applies against capital gains. It cannot offset employment income, interest or dividends.

Why do it?
The tax refund is attractive in itself - it is money in the pocket. Beyond that, for investors who intend to stay invested, who do not want to spend the capital or the refund, tax loss selling can provide a significant benefit. For example, imagine an investment that dropped a lot during the 2008 crash and has not yet recovered. The investor is in for the long haul and thinks it or a similar investment will recover and so wants to stay in the market. The following table shows how the numbers can work for the investor by a comparison of a) tax loss selling or, b) continuing to hold the investment that has gone down.

Example Assumptions:
  • $5000 capital gains in previous years - tax was paid at the time
  • $5000 paper loss on current investments is realized through a sale
  • loss is claimed against previous gains, netting a tax refund
  • tax refund is reinvested
  • investment is then held for ten years; both tax loss sale and hold get the same subsequent return
  • scenario 1 - low growth of 3.3% per year
  • scenario 2 - faster growth of 6% per year
Example Table

Example Results:
  • tax loss sale produces higher after-tax wealth (see the green cells) whether the investment grows slowly or quickly afterwards, even when the "hold" investor has no taxes to pay at all down the road
  • the higher the rate of growth in the investment, the more tax loss selling pays off in eventual net wealth
  • the higher tax bracket of the investor, the greater the benefit because there would be a larger refund to re-invest
  • tax loss selling (example not shown in table) even pays off when the investor moves into a much higher tax bracket by the time of cashing out
Tax loss selling gets its advantage the same way that RRSPs do. The combination of getting a tax refund, which creates a larger initial investment amount if the refund is re-invested, plus the tax-deferred growth of that larger initial amount (highlighted in the orange cell) generates greater net wealth down the road.

This logic indicates the circumstances when tax loss selling should be done or not:
  • do it to claim against past capital gains on which you have paid income tax
  • do it if you have realized capital gains in the current year against which you have paper losses that can be realized and applied to reduce or eliminate income tax on the gains
  • defer realization of capital gains as long as possible - the longer you can keep the investment and defer taxation, the more the full amount can grow. Of course, if you think the investment's prospects are negative or you have a much better investment in mind, then selling also makes sense. Letting your investing be driven by taxes is a mistake. It's better to make a profit and pay tax than to make a loss and pay no tax.

How to do it
Carrying out tax loss selling properly must conform to the rules of the tax authority, the Canada Revenue Agency (CRA). That can be tricky. Here are a few resources to help:
The December 31st deadline for transactions (trades of stocks and mutual funds at latest Dec.24th) to count in the 2009 tax year is fast approaching. Take a look at your taxes for past capital gains and your portfolio for paper losses to see if there is an opportunity to gain from tax loss selling.

Disclaimer: this post is my opinion and for information only and should not be construed as investment advice or recommendations. Nor is it to be taken as tax advice, merely information to get started. To be sure, consult an accountant.

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