There are certain losses in life which, if not handled properly, can lead to heartache. But handle them well and your losses can be beneficial in the long run.
My cousin, Paul, has handled one such loss quite well. You see, he's lost most of his hair. He went to the barber the other day and found out that it was going to cost him $26 for a haircut. "Joe, how can you possibly charge me $26 when I barely have any hair?" Paul said to the barber. "How about I pay you $12 to find my hair, then I'll cut it myself." The fact that he has lost his hair doesn't bother Paul one bit. He laughs about it all the time.
How do you handle your losses? Let's forget about your hair for a minute. Let's talk about your portfolio.
THE STRATEGY
As year-end approaches, many investors will be scouring their portfolios looking for investments that have dropped in value to sell them before year-end so that the capital losses can offset capital gains that might otherwise give rise to taxes.
Many will sell investments that have dropped in value without thinking twice about what they're doing. Before you pull the trigger, consider the following questions:
1. Are you unhappy with the investment? If you don't like that loser in your portfolio any more, perhaps because its fundamentals have changed, or you see a better opportunity elsewhere, then it may be worth selling for that reason alone, regardless of taxes. But what if you still like the prospects of the investment? Then ask the next question:
2. Do you have capital gains this year or in the prior three years against which to offset your capital losses? If so, by all means go ahead and sell that loser to trigger some losses to offset those gains. This will save you tax. To the extent capital losses aren't used in the current year, they can be carried back up to three years to offset capital gains in the past, which can result in a refund of taxes paid in the past.
But what if you answer "no" to these questions? In this case, give serious thought to holding the investment. By selling, you might just incur transactions costs for no reason. If your investment does rebound as you hope and expect, holding the investment will have been the least costly and most efficient approach.
THE CONSIDERATIONS
I know what many of you will be thinking: "Even if I still like the investment and have no capital gains to offset, why not sell anyway and reinvest in the same investment or something very similar?" The rationale is that it's always good to have capital losses available to offset future capital gains (capital losses can be carried forward indefinitely).
Be careful. If you sell a loser and reinvest in the same or an identical security, you could face the superficial loss rules. These rules simply say that when you sell a security at a loss and you acquire and continue to hold the same or identical securities in the period that is 30 days prior to or after your sale, your capital loss will be denied.
If you insist on triggering a capital loss, you might consider investing is something similar, but not the same or an identical security. The Canada Revenue Agency explains the concept of an "identical property" in Interpretation Bulletin IT-387R2 (available at www.cra.gc.ca) by saying that these are "properties which are the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another."
CRA goes on to explain that it's "necessary to compare the inherent qualities or elements which give each property its identity." This would include looking at specific rights attached to a security.
If, for example, you sell shares of ABC Corp. for a loss on the open market and then acquire and continue to hold the same class of shares within 30 days, your loss will be denied.
But what if you sell one index fund or exchange-traded fund and acquire a different one that is designed to mirror the same index? It's less clear in this case that you've acquired an "identical property," although you can make an argument they are not identical properties if the underlying basket of securities or their weightings are at all different from each other. This may allow you to switch to a very similar index fund or ETF without worrying about your loss being denied.
Tim Cestnick