As the year draws to a close, most Canadians are dusting off their winter boots, shovelling snow and planning for the holidays. But for many investors it also means it's time to consider using an important financial planning tool – tax-loss selling.
Tax-loss selling is simply selling an asset at a loss in order to reduce or eliminate the capital gain produced by other investments. It allows the investor to avoid paying capital gains tax on recently sold or appreciated assets.
So who should consider doing some tax-loss selling?
"Like an old pair of jeans that no longer fits, selling a security that no longer belongs in a portfolio for tax-loss purposes – and investment considerations – makes sense for almost all investors," says Stan Wong, a director and portfolio manager with Scotia Wealth Management in Markham, Ont. He notes that tax-loss selling could be considered more powerful for individual investors in the highest marginal tax brackets.
To realize the tax loss, you simply sell the asset, calculate the difference between the sale proceeds and the purchase price, then include the amount in your annual tax filing. Tax-loss selling not only applies to stocks but also mutual funds, exchange-traded funds and real estate such as rental property or family cottages. It cannot apply to your principal residence.
One important rule is that so-called "wash trades," or "superficial losses," are not allowed. That is, if an investor sells the asset, he or she cannot repurchase it within 30 days. Neither can an affiliated entity such as a spouse, a corporation controlled by the individual, or a trust where they hold a beneficial interest.
A significant advantage to tax-loss selling is that the capital loss can be applied to tax years other than the year in which you sell the asset. If it is not needed in the current tax year, it can be saved for future years, or even applied retroactively against taxes going back as far as three years. So if you don't have significant capital gains in the current tax year, it can make sense to apply the loss to previous years, or wait for a year to come.
While there are obvious benefits to tax-loss selling, investors should not simply sell every one of their assets that have lost value this year.
"Any decision to sell a security should be driven primarily by investment considerations, not just the desire to eliminate or reduce taxes," says Mr. Wong. He notes that if an individual investor owns a security at a loss but it looks to be rebounding or has positive near-term fundamentals, it may be wise to stay with the security despite any advantages of tax-loss selling.
But how should you decide whether to sell a specific asset?
Jeff Evans, executive director of quantitative strategy at CIBC World Markets, takes an analytical approach. In a recent report he says that while tax-loss selling is widely utilized, it is rarely approached systematically. He says investors often sell their worst performers indiscriminately to maximize tax deferrals, giving limited consideration to transaction costs and future expected returns.
The benefits of tax-loss selling can be improved through techniques such as trade timing and screening.
Mr. Evans has found, for example, that tax-loss selling is best performed early, as the majority of candidates underperform the market by 4 to 5 per cent from mid-November to late December. His data shows late December is often the worst time to engage in tax-loss sales, as most stocks experience a rebound when selling subsides in January.
Mr. Evans has also found that roughly 60 per cent of candidates continue to underperform the market in the new year, highlighting the important role that price momentum plays within the Canadian equity market. That also means that roughly 40 per cent of candidates will produce positive returns during the following season.
Tax-loss harvesting is another strategy that investors should consider, Mr. Wong says. That's the process of tax-loss selling but then replacing the sold security with a similar one, maintaining similar portfolio exposure and expected returns. He says shareholders of Nike Inc. should consider replacing their holding with shares of Adidas AG or Under Armour Inc., for example.
Mr. Evans's research reveals a similar opportunity in the precious metals sector: swapping Detour Gold Corp., Franco-Nevada Corp. or Tahoe Resources Inc. for Barrick Gold Corp., Yamana Gold Inc. or Eldorado Gold Corp.
Sell or hold?
Jeff Evans, executive director of quantitative strategy at CIBC World Markets, has developed a model to help determine which stocks to keep and which to sell. The model takes into account value, quality and, to a lesser extent, momentum.
Here are this year's top Canadian tax-loss-selling candidates, according to Mr. Evans's research:
- Intertain Group Ltd.
- Sandstorm Gold Ltd.
- Detour Gold Corp.
- Canfor Corp.
- Baytex Energy Corp.
These stocks have performed poorly in 2016 but should be held, according to Mr. Evans:
- Home Capital Group Inc.
- Boardwalk REIT
- Barrick Gold Corp.
- Aecon Group Inc.
- Yamana Gold Inc.
Stan Wong of Scotia Wealth Management considers these stocks good tax-loss selling candidates given their uncertain financial positions:
- BlackBerry Ltd.
- Valeant Pharmaceuticals International Inc.