Tax Loss Selling with Canadian ETFs

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, US, 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 advisor before making any transaction for tax purposes.

29 Responses to Tax Loss Selling with Canadian ETFs

  1. Matt Becker October 21, 2013 at 9:58 am #

    The ability to tax-loss harvest is something I’ve been tracking for about 1.5 years now but haven’t yet had the opportunity. For many people, at least in the US, there’s the opportunity to tax-gain harvest as well. I actually have a friend I was just talking to who holds a few stocks given to her long ago by her grandmother. It’s an incredibly un-diversified portfolio but they also have big gains. But she’s very far from the top of the 15% tax bracket, meaning the long-term gains would be un-taxed this year. Of course she needs to speak with a tax professional before acting, but the potential there is a good one.

  2. gil October 21, 2013 at 10:59 am #

    Another good reason for the HXT & HXS.

  3. Tony October 21, 2013 at 1:10 pm #

    I realized this when I was looking to make the switch from VCE to VCN and locking in potential Capital gain while still having the relatively same exposure to the Canadian market.

  4. matt October 21, 2013 at 1:37 pm #

    This is off-topic but didn’t know where else to ask. In your model portfolio comprised of TD e-series stocks, why do you recommend 20/20/20 split for td us, canadian and international index?

  5. Brad_G October 21, 2013 at 4:20 pm #

    @Gil – >>>Another good reason for the HXT & HXS.

    Not sure what you mean and am wondering if you’re referring to the swap structures of these ETF’s. Does that make them sufficiently different than a typical TSX index ETF?

  6. Canadian Couch Potato October 21, 2013 at 4:25 pm #

    @Brad G and gil: HXT and HXS are designed to defer taxes on dividends. They can still incur still incur capital gains or losses like any other type of ETF.

    @matt: I address the reasons for the 20/20/20 split here:
    http://canadiancouchpotato.com/2012/05/22/ask-the-spud-does-home-bias-ever-make-sense/

  7. David L October 21, 2013 at 10:40 pm #

    Earlier this year, I sold XIC and bough VCE. Before I did that, I asked my accountant, and he said that there shouldn’t be any problem since they have vastly different composition, even though both pretty much track the TSX.

  8. Be'en October 22, 2013 at 2:23 am #

    A bit off-topic, is there any advantage in locking (crystallizing) capital gains periodically of assets held in registered accounts (where taxes on gains are not an issue)?

  9. Don October 22, 2013 at 8:29 am #

    Dan,

    I’m employing a fundamental index strategy (akin to your über tuber portfolio). What is your opinion on tax loss harvesting in this situation? Would it be prudent to switch between CRQ and ZCN returning to CRQ outside the 61 day period or are fundamental and cap weighted indices sufficiently different that this simply a way to sell low.

    Thanks,
    Don

  10. Canadian Couch Potato October 22, 2013 at 9:54 am #

    @Be’en: I cannot think of a situation where that would make any sense.

    @Don: If you were trying to harvest a large loss, that would probably be fine. You could always switch back to the original ETF after 30 days to get back to the intended exposure. There is certainly the possibility of tracking error during the month you hold the new security, but it’s not likely to be large and there’s a 50% chance it would work in your favour.

  11. Justin Bender October 22, 2013 at 10:48 am #

    @Don – you could also consider switching from the CRQ to XCV, as these securities would be expected to have lower tracking error relative to CRQ and ZCN.

  12. Songbo October 23, 2013 at 12:02 am #

    @Be’en Make you have the right asset allocation. Don’t be subjected to loss aversion.
    http://www.finiki.org/wiki/Behavioural_pitfalls#Loss_aversion

  13. Be'en October 23, 2013 at 2:08 am #

    Thanks Dan and Songbo (reread the list in the link 🙂 ..

  14. Holger October 23, 2013 at 12:16 pm #

    Good advice, Dan!

    Earlier this year I harvested the REIT dip by switching from ZRE to XRE. Given that the underlying indices are different (market cap based vs. equal weight), I think I’m OK there.

    Although I like the equal weight approach better, I’m glad that I didn’t just stay uninvested for 30 days. I would have missed a 3% rise if I had. Not sure if/when to switch back, though …

  15. Don October 24, 2013 at 9:24 am #

    Justin and Dan, as usual great advice. Good point Justin that there are other value ETFs that would more closely track a fundamental index. Cheers.

  16. Jas October 29, 2013 at 5:03 pm #

    @CCP:
    As your portfolio gets bigger (over 100 to 500k for example), is it easy to sell all your shares of one ETF in one single transaction, to replace it for another similar ETF? Or this should be done in multiple smaller transactions?

  17. Canadian Couch Potato October 29, 2013 at 5:14 pm #

    @Jas: I don’t see any advantage in selling an ETF holding using multiple transactions. As long as you place a limit order properly your shares will all be sold promptly, though in some cases you will get more than one price, especially if it’s an odd lot. For example, when selling 1,050 shares you might see 1,000 sold for $20.50 and 50 sold for $20.49.

  18. Karen November 3, 2013 at 3:43 pm #

    Hi – I’ve read the white paper and am having trouble understanding the advantage of tax loss selling. In your example of selling XEC and replacing it with VEE, the new ACB for the purchase of VEE will be 93.7K, so capital gains will eventually have to paid on any increase over that. If you had done nothing (kept XEC), the ACB was 100K and the capital gain would have been on any increase above 100K. So even though you could have a 6.3 K capital loss to work with from the ‘harvest’, you will also have a capital gain to eventually pay (on VEE) that is 6.3 K higher than what you’d owe on just keeping and eventually selling XEC. Or am I missing something?

  19. Canadian Couch Potato November 3, 2013 at 4:09 pm #

    @Karen: The benefit tax-loss selling is generally tax deferral, not tax avoidance. So while it’s true you may eventually incur capital gains taxes on the new ETF when you sell it, you may be able to use your harvested loss to offset gains elsewhere in the portfolio, which are likely to arise during the course of rebalancing. There is also some potential for overall tax reduction if you can defer the gain to a year when you’re in a lower tax bracket. In many ways these benefits are similar to what you’d get from an RRSP.

  20. Ahsen November 12, 2013 at 10:45 am #

    Hi! Huge fan of your blog!

    Very important topic considering we are in tax loss seling season!
    I currently hold Barrick Gold and was considering of selling it to realize some losses but I also don’t want to lose my exposure to gold. If I replace it with an ETF such as XMA or XGD that has Barrick as one of the holdings, would that be considered a superficial loss?

  21. Canadian Couch Potato November 12, 2013 at 11:09 am #

    @Ahsen: That would not be considered a superficial loss, and it’s actually a common strategy to sell a stock or two and then a purchase sector ETF that includes those stocks to maintain similar (but not identical) exposure.

  22. kulvir December 12, 2014 at 3:10 pm #

    Hello Dan,

    I have read the blogs on tax loss harvesting as well as your white paper. I am trying to understand how the application of the superficial tax rule whereby 30 days PRIOR to the sell date applies. Would you clarify 2 scenarios for me?

    Scenario 1: I own no stock other than $100 000 of VCE. I purchase the units 1 week ago. Today I decide to make use of tax loss harvesting and sell all my stock. I do not repurchase the same or identical stock for 30 days after the settlement date. Because I do not own the stock at all after 30 days after settlement, it is irrelevant that I bought it 1 week prior to selling it and part 1 of the superficial loss rule does not apply as part 2 of CRA the criteria is not met. Correct?

    Scenario 2: Identical to the first scenario except that I only sell half or $50 000 worth of my stock. Still I do not repurchase a same or identical stock for 30 days after the settlement date. Here the superficial loss rules are met as a purchase of VCE was made in the 30 days prior to selling AND I still owned shares in the stock 30 days after selling. Is this a correct example of how the “30 days prior” to sell date aspect of the superficial loss rule has meaning?

    Basically its easy for me to understand that you cannot repurchase within 30 days after settlement but its not so clear to me the importance of the 30 days prior aspect of the 61 day window.

    Would you kindly clarify?

  23. Canadian Couch Potato December 12, 2014 at 7:05 pm #

    @kulvir: This is a great question. From what you describe, Scenario 1 is simple: no superficial loss.

    In Scenario 2, however, I believe you would trigger a superficial loss. Had you held VCE for more than 30 days before making the partial sale you would have been fine. Or if you had sold all the shares instead of half you would also have been fine (that’s Scenario 1). But the key point here is that the initial $100K purchase was only a few days before the $50K sale, and therefore the purchase falls within the 61-day window. And you still hold shares 30 days after the sale. So you have satisfied both criteria for a superficial loss:

    A. You bought identical property during the period starting 30 calendar days before the sale, and ending 30 calendar days after the sale; and
    B. You still own the identical property 30 calendar days after the sale.

    As always, check with a tax expert if this is a real predicament and not just a hypothetical one.

  24. kulvir December 12, 2014 at 7:34 pm #

    Thanks,

    I really appreciate your response.

    My situation fits scenario 1 with VCE.

    After reading all about tax loss harvesting last night I was trying to understand when the 30 day prior rule would actually come into play and all I could imagine was scenario 2. I wanted to make sure I understood properly.

    Is VCN considered not identical and an acceptable alternative to VCE?

    From what I gather with all the small cap stocks in VCN they should be considered different indexes.

    Thanks!

  25. Canadian Couch Potato December 13, 2014 at 8:34 am #

    @kulvir: VCE and VCN certainly track different indexes so they should not be considered identical property.

  26. Stefan July 2, 2015 at 3:24 am #

    Hi Dan, big fan of your blog!

    I invest within my medical professional corporation and I’m considering ETF’s. I try to keep most of my earnings inside the business account due to the much more favourable taxation and thus have more to invest than if it were all personal income. However, being a non-registered as well as non-personal account, any gain from fixed-income investments within the corporation will lead to an insane amount of taxation that’s higher than the personal max marginal rate, about 46% or so. Could one use a capital loss from an equity ETF to offset the capital gain from a fixed-income ETF like a bond ETF? Thanks for your consideration.

    Stefan

  27. Canadian Couch Potato July 2, 2015 at 8:47 pm #

    @Stefan: You can use any capital loss to offset any capital gain, regardless of whether they came from equities or fixed income.

  28. Mahsa Shokouhi December 31, 2015 at 9:38 am #

    Hi

    I’d very much appreciate your comments on whether or not any of the following two scenarios would be considered superficial loss:

    1. Switching between two funds tracking the same index, one of which is currency-hedged. For example, TD has two mutual funds: US index and US index currency-hedged (both track S&P500). Would switching between the two funds at a loss be considered a superficial loss?

    2. Selling some units of a mutual fund 2 weeks after purchase and not buying back the units in the next few months.

    Many thanks in advance
    Mahsa

  29. Canadian Couch Potato December 31, 2015 at 10:16 am #

    @Mahsa: As you can appreciate, I cannot offer you a formal tax opinion, so these are questions you should direct to your accountant or tax preparer. But in general:

    – The only guidance we have CRA regarding superficial losses and index funds is a 2001 bulletin stating that “an investment in a TSE 300 index based mutual fund with a financial institution would, in our view, generally be considered identical to an investment in a TSE 300 index based mutual fund of another financial institution.” This has generally been interpreted to mean that any two index funds with the same benchmark would be considered “identical property.” You could certainly make a compelling argument that hedged and unhedged S&P 500 funds track different indexes: the fund documentation lists different benchmarks and these clearly have very different exposures. After all, if they were identical, why would TD offer both versions? But of course, CRA may interpret things differently.

    – Scenario 2 as described is not a superficial loss. You do not have to sell all your units in a fund to book a capital loss, and there is no minimum holding period.

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