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Every December I hear about tax-loss harvesting. What is it, and why would anyone do it?

No, it's not something farmers do. Tax-loss harvesting is just another name for tax-loss selling, which is a strategy some investors employ – typically toward the end of the year – to minimize capital gains taxes.

It works like this. Say you sold some of your winning stocks during the year. Assuming you held the stocks in a non-registered account, you'd have to pay capital gains taxes. But if you also own shares that have dropped in value, you could sell them and use the capital losses to offset your gains, thereby reducing or eliminating the tax hit. (You can also use capital losses to offset capital gains on an investment property, for example, but not other forms of income.)

There are some rules to keep in mind, however. You can't sell a losing stock to trigger a capital loss for tax purposes and immediately buy the stock back again. The Canada Revenue Agency considers that a "superficial loss," which can't be used to offset capital gains. You must wait at least 30 days before repurchasing a security, or CRA will deny the loss.

Furthermore, you can't get around the rule by immediately repurchasing the security in a different account such as an RRSP, or by having a spouse buy it. Purchasing the shares in a corporation controlled by you or your spouse also won't work. The idea here is that you can't claim a tax loss if you, or someone affiliated with you, maintains control of the shares.

The 30-day restriction also applies to the period before you sell the shares. In other words, if you own 100 shares of XYZ Corp. that you're planning to sell for a tax loss, and you purchase an additional 100 shares less than 30 days before the sale so that you'll maintain ownership of the same number of shares after the sale, that's also considered a superficial loss.

There are ways around the problem, however.

Say you still like the fundamentals of a stock that's dropped in value. You want to sell it for a tax loss, but you don't want to wait 30 days to repurchase it. One strategy is to purchase a similar security whose performance is strongly correlated with the stock you are selling. That way you get the tax loss, but you won't necessarily miss out on any potential gains.

On its website, exchange-traded fund company iShares Canada provides some examples of this strategy.

An investor who owns Royal Bank of Canada (RY-TSX), which is down about 7 per cent this year, could sell the stock for a tax loss and immediately buy the iShares S&P/TSX Capped Financials Index Fund (XFN). According to iShares, RY has a five-year correlation of 0.82 to XFN, meaning the two securities move up and down together, though not perfectly.

Similarly, an investor who owns Canadian Natural Resource (CNQ), which is down about 16 per cent this year, could sell it for a tax loss and buy the iShares S&P/TSX Capped Energy Index Fund (XEG). These two securities have an even stronger correlation co-efficient of 0.92.

But taxes should not be your only consideration, experts say.

"It's important to note that investment fundamentals should still play the most important role in determining which stocks to sell. Harvesting the tax loss is a secondary consideration," Ross McShane, director of financial planning with McLarty & Co. in Ottawa, writes in the November/December issue of Canadian MoneySaver magazine.

Here are a few other things to keep in mind.

For a capital loss to be recorded in 2011, trades of Canadian securities must occur no later than Dec. 23, because stock and fund transactions take three business days to settle and Dec. 26 and 27 are statutory holidays. Capital losses must first be applied against capital gains in the current year. If your capital losses exceed your capital gains in the current year, the net capital loss can be carried back up to three years or forward indefinitely to offset capital gains in other years.

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