Tax-loss selling—also known as tax-loss harvesting—is a technique for proactively realizing capital losses in your portfolio. It might seem counterintuitive: why would you want to “sell low”? In fact, harvesting losses in an ETF portfolio is a smart strategy that can allow you to offset taxable gains you have realized in the past, or defer taxes on gains you’ll realize in the future.
My colleague Justin Bender and I co-wrote a white paper on tax-loss selling with ETFs way back in 2013. Justin updated the paper late last year, and it turned out to be good timing: the market crash of spring 2020 provided an ideal opportunity to put this strategy to the test.
Justin’s latest video provides an overview of the main concepts in the white paper, including the superficial loss rule. According to this rule, if you sell a security to crystallize a capital loss, you cannot:
- buy, or have the right to buy, the same or identical property, during the period starting 30 calendar days before the sale, and ending 30 calendar days after the sale; and
- still own, or have the right to buy, the same or identical property 30 calendar days after the sale.
If you violate these conditions, your loss will be deemed “superficial,” and you won’t be able to use it to reduce taxable gains.
The superficial loss rule can be confusing, and the subtleties can trip up investors who are trying to harvest losses in their ETF portfolio. We’ve cobbled together some of the most common head-scratchers and provided clarification to make sure you don’t fun afoul of the Canada Revenue Agency.
I use the iShares Core S&P/TSX Capped Composite Index ETF (XIC) for my Canadian equities. If I sell this fund to harvest a loss, can I replace it with the BMO S&P/TSX Capped Composite Index ETF (ZCN)? Surely these two ETFs are not “identical property,” since they are from different fund providers.
Your logic makes sense, but the taxman disagrees. Way back in 2001, the CRA issued a bulletin stating that two index funds tracking the same benchmark are identical properties in this context. So if you sell XIC and replace it with ZCN, your trade will result in a superficial loss, as both ETFs are pegged to the S&P/TSX Capped Composite Index.
Many tax specialists have argued this tax bulletin is badly outdated, now that index-tracking funds are far more common that they were 20 years ago. Specifically, the CRA argues that identical properties are “the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another.” But funds tracking the same index might not fit that description.
Example: suppose you harvested a loss in the iShares MSCI Emerging Markets Index ETF (XEM) and then swapped it for the BMO MSCI Emerging Markets Index ETF (ZEM). These two funds track the same benchmark, but they are hardly “the same in all material respects.” XEM has a fee of 0.80% and gets its exposure by holding an underlying US-listed ETF. The BMO version has a much lower fee of 0.27% and holds its stocks directly, which is more tax-efficient. Investors could certainly argue they would “have a preference for one as opposed to another,” but a strict interpretation of the bulletin would render this a superficial loss.
Picking a fight with CRA is a bad idea, so if you sell any ETF at a loss, we recommend replacing it with one tracking a slightly different index. For Canadian equities, you could replace XIC with the Vanguard FTSE Canada All Cap Index ETF (VCN). For emerging markets, if you sell XEM or ZEM, your replacement could be the iShares Core MSCI Emerging Markets IMI Index ETF (XEC), which tracks a broader index.
We’ll have more suggestions for tax-loss selling pairs in my next post.
Just over a month ago, I sold XIC to harvest a loss and purchased VCN as a replacement. Now that the 30-day waiting period is over, should I sell VCN and buy back XIC?
One benefit of using total-market ETFs for tax-loss selling is that the benchmark indexes do not vary much. The S&P/TSX Capped Composite Index (tracked by XIC) and the FTSE Canada All Cap Domestic Index (tracked by VCN) are not identical, but their differences are tiny. In the revised white paper, Justin compared the performance of the two benchmarks over the 10 years ending in 2018 and found their monthly tracking error to be a minuscule 0.118%, which means they moved almost in lockstep. And since both ETFs have the same low fee, they’re effectively interchangeable.
There’s another reason not to switch back to your original ETF after harvesting a loss: if the market recovers quickly, you might end up realizing a capital gain. This spring provided a textbook example. If you swapped XIC for VCN near the market bottom on March 23, 2020, you would have paid less than $23 for units of your new Vanguard ETF. Then the market rebounded amazingly quickly, and by April 29 the fund was trading at over $30. Selling VCN at that point would have realized a capital gain of about 30%, defeating the purpose of your original tax-loss selling trade.
What if I harvest a loss and then my replacement ETF falls even further? Should I harvest that loss, too?
In most cases, yes. When the market falls hard and fast there may indeed be an opportunity to harvest more than one loss in the same asset class. The COVID crash of 2020 provided just such an opportunity.
Here’s a real example: one of our clients had a large holding in VCN that was showing a decline of about 6% and $9,000 on March 10. We sold it to harvest the loss and replaced it with XIC. But the Canadian market continue to plunge, and by March 27 that new holding was down another 14% and more than $21,000. We harvested this loss, too.
Of course, because our second tax-loss trade came only 17 days after the first, we could not just switch back to VCN. That would have resulted in a superficial loss. So in this unusual case, we had to choose a third Canadian equity ETF to use as our replacement. We ended up using the iShares S&P/TSX 60 Index ETF (XIU), though other options would have been the Franklin FTSE Canada All Cap Index ETF (FLCD) or the TD Canadian Equity Index ETF (TDAM).
This year, I made my RRSP contribution at the deadline on March 2, and I bought an iShares ETF. I also held the same ETF in my taxable account, and when the market tanked later that month, I harvested the loss and replaced it with a similar Vanguard ETF. Now my accountant is saying the loss will be declared superficial. How can this be?
This part of the superficial loss rule confuses many investors. Most people understand they can’t buy the same ETF immediately after selling it to harvest a loss: they know they have to wait 30 days. What they often overlook is that you also cannot buy the same ETF (or identical property) during the 30 days before you harvest the loss.
As described in our white paper, it’s helpful to think of a 61-day period surrounding the tax-loss trade: you need to be aware of any transactions you make during the 30 days before the settlement date, and the 30 days following.
This is why you should check your recent transaction history before making a tax-loss selling trade. If you made any purchases of the same or identical property in your other accounts during the prior 30 days, your loss could be deemed at least partially superficial.
Remember, too, that in order for the loss to be disallowed, you need to still hold the identical property 30 calendar days after the sale. So if you had noticed your mistake shortly after harvesting the loss in your taxable account, you could have immediately sold the ETF in your RRSP and dodged the bullet. As long as the RRSP trade settled less than 30 days after the sale in the taxable account, the loss would have still been allowed.
My husband and I keep our finances separate: I manage my own ETF portfolio, but he uses an advisor. What could go wrong?
Having more than one portfolio manager for your household accounts can cause problems if you’re doing tax-loss selling. We’ve already seen that your loss can be declared superficial if you buy an identical property in one of your other accounts within the 61-day window. Well, the same is true of your spouse buys that ETF in his or her account. (It’s also true if you buy the same or identical property in a corporate account controlled by you or your spouse.)
We’ve seen this potential danger in our own practice. Occasionally a client or their spouse will have a self-directed account in addition to the portfolio we manage for them. Since we make relatively frequent tax-loss selling trades, we recommend these clients avoid using the same ETFs we hold in their managed accounts to make sure we don’t inadvertently create superficial losses.
If you and your spouse manage your investments separately, or if your family uses more than one advisor, be extra diligent when tax-loss selling. The easiest way to stay out of trouble is to avoid using the same securities: for example, if you both invest in ETFs, you could agree to use different fund providers.
I hold the same ETFs in my TFSA and my taxable account. I have a dividend reinvestment plan (DRIP) set up for all the holdings in my TFSA. Will this be a problem if I harvest a loss?
Yes, using DRIPs makes it easy to create superficial losses accidentally. Each reinvested dividend involves purchasing new ETF units, so if any of these transactions falls within the 61-day window, it could result in a superficial loss.
Suppose you held 1,000 shares of VCN in both your non-registered account and your TFSA. In late March 2020, you sold your non-registered holding to harvest the loss and replaced it with XIC. So far so good. But then VCN declared a dividend of $0.16 per unit on March 31, and if you had a DRIP set up in your TFSA you would have received five new shares. That would result in a partial superficial loss, which would apply to five of the 1,000 shares you sold.
As you can imagine, this creates a bookkeeping nightmare. If you regularly engage in tax-loss selling, you may want to cancel your DRIPs altogether, or consider using different ETFs in your various accounts so this doesn’t happen.