No one likes to see their investments plummet in value, but it’s going to happen many times over your lifetime. If you’ve got a strategy for tax loss selling, you can make the best of the situation by harvesting capital losses that can be used to offset capital gains. That gives you an opportunity to reduce or defer taxes in the future, or even recover taxes you paid in past.

In a blog post on September 26, I noted that Canadian equities had fallen by about 5% since the beginning of the month, which could have triggered one such opportunity. (A useful rule of thumb, courtesy of Larry Swedroe, says a security should be sold when the loss is at least 5% and at least $5,000.) If you had recently made a large purchase of the Vanguard FTSE Canada All Cap (VCN), for example, you might have sold it that week to realize a capital loss and then repurchased the iShares Core S&P/TSX Capped Composite (XIC) or a comparable fund. As long as the replacement ETF tracks a different index you’ll maintain your exposure to Canadian stocks while also steering clear of the superficial loss rule.

I’ve written about this idea several times, but selling is only half the story. Remember, you can’t repurchase the original ETF for at least 30 days, and a lot of things can happen during that time. If markets recover swiftly, your replacement ETF will rise in value. So when you switch back to the original ETF you might end up locking in a capital gain that offsets your harvested loss, making the whole exercise an expensive waste of time.

Alternatively, markets could continue to fall over the next 30 days and allow you to harvest another loss when you switch back to the original ETF. As it turns out, that’s exactly what would have happened had you replaced VCN with XIC on the day of my original post.

Deeper down the rabbit hole

A trade on September 26 would have settled on October 1 (three business days later). You would have then needed to hold the replacement ETF until October 28, since a sale on that date would have settled October 31. (The 30 days between settlement dates would have allow you to avoid the superficial loss rule.) Here’s how the net asset value for both ETFs changed between the transaction dates:

September 26$30.25$23.74
October 28$29.43$23.15

As the Canadian equity market continued to fall in October, your opportunity for tax loss harvesting would have increased. Selling XIC on October 28 would have triggered another capital loss equivalent to about 2.5% of the holding. So if you started September with a $100,000 holding and locked in a $5,000 loss near the end of that month, you would have emerged 30 days later with over $7,000 in capital losses.

Of course, it’s not all wine and roses: your Canadian equity holding is still down more than 7% in two months. But that would have been true even if you had done nothing. As long as the markets move higher in the future—and we wouldn’t be investing if we didn’t expect that—you’ll be far better off if you were able to realize that loss before the recovery.

This just in from Justin

If you’d like to see a real-world example of a tax loss harvesting trade, visit Canadian Portfolio Manager, the brand new blog created by Justin Bender, my friend and colleague at PWL Capital. Justin harvested some losses for our clients by switching from one Dimensional fund to another in late September and then switching back last week. By doing so he was able to realize losses between $8,000 and $11,000 for the clients.

Justin’s new blog will feature insights into how he manages portfolios, and it includes a host of free resources including white papers, calculators, and ETF model portfolios. In the future, Justin and I will be collaborating on many articles and tools to help investors make better decisions. We’ve already got a long list of ideas, so stay tuned.