Last October, Justin Bender and I published a white paper on tax loss selling with ETFs. It explained how index investors can harvest capital losses while maintaining a consistent exposure to the equity markets. We were proud of the paper (which was even adapted as a continuing education course for advisors) but it proved to be rather useless during the subsequent year. Indeed, it would have been irrelevant during much of the last three years, as the charging bull market never stopped to catch its breath. There were simply no capital losses to harvest.
Well, it may be time to dust off the paper. September has been a difficult month for stocks, especially in Canada, and investors with large portfolios might now have their first tax-loss selling opportunity since 2011.
No gain, no pain
Let’s start with a refresher on how tax-loss selling works. In a non-registered account, when you a sell a security that has declined in value, you realize a capital loss. You can use these to offset any capital gains you’ve incurred in the current year, which can reduce your tax bill. Moreover, unused losses can be carried back up to three years, or carried forward indefinitely to offset future capital gains.
As we explain in our white paper, ETF investors can take advantage of market downturns by selling a fund that’s showing a significant loss. Then they can immediately repurchase a similar but not identical ETF to avoid the superficial loss rule. This allows them to reap the tax benefit without meaningfully changing their market exposure.
Wake me up when September ends
PWL Capital recently adapted its portfolio management software to automatically identify these tax-loss selling opportunities in client accounts. Justin asked the programmers to use Larry Swedroe’s rule of thumb, which says a security should only be sold when the loss is at least 5% and at least $5,000. For months the software generated blank reports as markets continued to rise. But this week it finally flagged a few accounts: they were new clients who bought their Canadian equity holdings only recently.
Consider the Vanguard FTSE Canada All Cap (VCN): it closed at $31.56 per unit on September 2, and by the 25th it had fallen to $29.97, a decline of just over 5%. A client who had purchased at least $100,000 of this ETF at the beginning of the month would now satisfy both of Swedroe’s criteria.
So, if you’re in this predicament, should you immediately sell VCN and buy a replacement? (In this case, you could use the iShares Core S&P/TSX Capped Composite (XIC) or the BMO S&P/TSX Capped Composite (ZCN).) Not necessarily. I asked Justin to explain how he handled the decision for our clients:
- The first step, he says, is to check whether you have crystallized any capital gains this year (or if you plan to realize any before the year is out). If so, any harvested loss would offset these first.
- Next, check whether you realized any capital gains during the previous three years.
- Now consider your marginal tax rate. If your capital gains were realized during a year when you had a low income, you may not have paid much tax: for example, an Ontario resident with an income of $30,000 would pay just 10% tax on an additional $5,000 of capital gains. This investor has less incentive to carry back losses than a high-income earner whose gains were taxed at 24%.
- Finally, consider whether you already have net capital losses carried forward from previous years. You can do this by checking your Notice of Assessment or the CRA website. (If your advisor is making these decisions, you can complete a T1013 form to allow him or her to check this information for you.)
After working through these steps with two clients, Justin arrived at different decisions. In the first case, he decided to harvest the loss for a client in a relatively high tax bracket who had $3,500 in capital gains from this year and last. But the second client already had large carried-forward losses from previous years, so Justin felt harvesting another $5,000 wasn’t worth the cost.
If you use a tax-loss selling strategy, it’s important to track your results so you can see whether you added value after costs. It’s possible, for example, that your replacement fund will go on to lag the original and undo your hard work. There are no guarantees with tax-loss selling, but if you follow a disciplined strategy like the one we’ve outlined here, it offers the potential for significant savings.
I started investing start of 2010. I have nothing but gains.
Unfortunately, I think for buy-and-hold couch potato types, tax loss selling will be quite rare. Basically until the next 2008/2009 style financial crisis.
I agree with slacker. This was an interesting read, but I think for most passive, long term investors it will prove to be more trouble than it is worth.
For example, I’m not really sure how it works in cases where you have been buying the same ETF year over year. If I’ve been buying, for example, 100 shares of XIC every year for the past 5 years, and in 2014 it loses 5% of its value, can I harvest a tax loss even if on average it has seen returns of 7% over the last 5 years? Can I only sell the 100 shares I bought at the beginning of 2014?
Whatever the answer to this question, it just seems like added complexity that will eventually result in some mistakes and is probably not worth it. The great pleasure of passive investing (at least for me) is that it is passive.
This is of course not to deride Dan’s article – a great read as always.
@Mike: No, you cannot harvest a loss on specific shares that are part of a larger holding. All of your shares have the same book value, which is based on their average cost. There’s no “first in, first out” or “last in, first out” provision like there is in accounting.
This means that if you started investing after mid-2009 and kept adding money to the same ETFs for the last five years, then you may well be in a position where you’ll never be able to harvest losses in those specific securities. But there are many investors who are not in that position. They may have recently switched to a new product, etc., like the examples in the post. Or they may be in a position to realize some gains now and repurchase a similar security as a replacement, which would “reset” the book value and make it possible to harvest losses in the future.
Let’s also remember that bear markets will be part of all investors’ lives, even though we haven’t seen one since 2009. I’m getting a bit worried that younger investors, especially, have been lulled into a false sense of security by the last five years.
If Slacker bought in 2010 then the time for tax loss harvesting(TLH) was in 2011, particularly for international stocks.
Anyone with a large unregistered portfolio interested in TLH should seriously consider alternative ETFs before adding to an existing position in a large capital gain position. This adds complexity but essentially creates alternate tax lots and more TLH opportunities.
Unlikely to be worth it for most readers of this blog but useful for some of us.
With such great gains for the last few years would it not also make sense to sell even some winners to crystallize gains even if it meant capital gains taxes are due? The tax has to be paid at some point and I don’t think it ever hurts to take a profit.
@Al: Selling some equities may indeed be necessary as a part of normal rebalancing during a long bull market, and this is usually wise even if it does mean incurring taxable gains. That’s one of the reasons why it pays to look for TLS opportunities, which might be used to offset at least some of these gains.
@Al: I think it’s important to emphasize that, as CCP says, selling positions for a gain makes sense in order to rebalance to your target asset allocation, but not more than that. Yes, the tax needs to be paid at some point, but there is a large benefit to deferring taxes. The longer the money is in your hands, the more it can compound for you. This is the precisely why RRSPs are valuable. So, certainly sell enough to get back to your target asset allocation (which matches your risk tolerance), but beyond that it would be counter-productive.
In situations where one doesn’t particularly want to hold an “almost-substitute” fund (for example, suppose I prefer VUN to one of the S&P500 funds), would you recommend buying the S&P fund but switching back to VUN after 30 days (to avoid the superficial loss), or simply keeping that money in cash for 30 days?
@Tyler: I definitely don’t recommend leaving the proceeds in cash. I would just switch back to the original holding after the 30 days are past.
Noob question; does this same circumstance apply to registered accounts? Or because they are not taxed on their capital gains is there is also no tax break for capital losses?
@Tycho: Tax-loss selling only applies to non-registered accounts.
is it okay to just keep all the interest/income investments in rrsp and equity in tfsa even if there is room in rrsp ? with tfsa now days it seems to me i could fill the tfsa up with equity and put the 40% allocated fixed income of bonds/gics in rrsp.
@Jake: Yes, that’s a perfectly reasonable asset location decision. Just remember that your first decision should be whether to contribute to an RRSP v. a TFSA in the first place. (That decision will depend primarily on your income level today and in the future.) If it turns out that an RRSP is a better choice, then you don;t necessarily even need a TFSA. Remember to make these decisions in the correct order: how much you can save, whether it should go in an RRSP or TFSA, an appropriate asset allocation, and finally, which asset class goes in which account.
curious on the recommended minimum for loss harvesting. since all tax deferral is good, why the minimum $5000.
@François: That’s just a rule of thumb, and others may decide to draw the line somewhere else. But tax loss selling does involve costs in the form of trading commissions, bid-ask spreads and the potential that the replacement fund will underperform the original. So, as with rebalancing, you can undo some of its benefits by doing it excessively.
@CCP. slightly off topic, but based on your answer to @Jake. Does it make sense to put money in my RRSP, even though i don’t need the deduction? I am going through a career change, with much lower income level over the next few years, but do still have savings and RRSP room from the year prior to the change. i figure worse case scenario and i never get to level of income and i need the money, i would take it out and claim my deduction then (if need be). at least this way i at least get interest earnings tax deferred (TFSA is and will be maxed out)
@François: Yes, it can indeed make sense to contribute to an RRSP and defer claiming the deduction if your TFSA is maxed out. As you say, you will enjoy tax deferral on the growth, and the nature of an RRSP means investors are less likely to dip into their long-term savings, so there’s a behavioural benefit, too.
if we were considering Tax loss selling, is there a point to now start considering off cycle rebalancing, or is this too much tweaking?
@françois: I’m not sure I understand your question. Are you asking whether you should combine tax loss selling (harvesting capital losses) with rebalancing (which often leads to capital gains)? If so, then sure, that may a good way to reduce your new capital gains and lower your tax bill in the current year.
In the process of transferring my accounts from Scotia to Questrade (BRUTAL timing, one week earlier and I would’ve been golden… I’m 25, trying to tell myself it’s just a blip!) I’m incurring some serious losses right now while the ‘all in cash’ transfer is being completed. I had some decent gains before the past week’s losses, and now that I will definitely be losing money, am I able to use that for capital losses? Or will they still count as gains since they are still up from the principle amount? Thanks
quick Question on Tax loss harvesting. I went through the analysis and it made sense to harvest loss with the recent dip in VCN, and my taxable situation, so i replaced it with XIC yesterday in my cash account. Do i now have to be careful to not buy VCN in any of my accounts over the next 30 days, when i go through my monthly cash-flow balancing at end of October. It will likely show buy canadian equity in my registered account, or is the issue of not being able to claim losses only when you transfer in kind from Cash to RRSP?
This post is turning out to be prescient. :)
@John: I’m a bit confused. If you currently have money being transferred “all in cash” from one brokerage to another, then you have been spared any losses that have occurred in the last few days. It wasn’t brutal timing, it was fortunate. Maybe I have misunderstood something. But to answer your question, you can only claim a capital loss if you sold the securities for less than their adjusted cost base. What happens in the market after the sale is irrelevant.
@francois: Great question. If you sold VCN with the intention of claiming a capital loss, you cannot buy it back in your RRSP during the subsequent 30 days or it will be deemed a superficial loss. Moreover, you need to make sure you did not buy shares of VCN in your other accounts during the previous 30 days, too. This is a part of the rule people often forget: the superficial loss rule applies to transactions 30 days before and 30 days after the sale, so it’s actually a 61-day window.
@CCP: I still see the funds in my Scotia account, so the transfer hasn’t been completed AFAIK (or the sale of my assets to cash from what I see in the account)…
@John: OK, if the funds have not actually been sold yet, then you would be able to claim any capital loss that might be realized when the sale actually goes through. You should receive a gain/loss report from Scotia at the end of the year and it will be itemized there.
@Dan. Agreed the post was timely. and your answer was aligned with my understanding, and it won’t be an issue this time, but i just wanted to make sure i add this process in my recipe book, to make it as formulaic as possible and remove any emotions.
@CCP: Thanks for the clarification!
Is tax loss selling allowed on etfs with foreign content? example does VCX or VXUS or SPY qualify for tax loss selling? Thanks.
@Shyam: Yes, any ETF can be used. As long as there is a capital loss realized on the sale it does not matter what the asset is.