Exchange-traded funds (ETFs) are prized for their low cost and liquidity, but they will also prove invaluable as a simple and effective tax-loss harvesting vehicle amid this year’s market rout.
Investors could always engage in tax-loss selling before the widespread use of ETFs but, given the proliferation of funds in recent years, it’s never been easier to gain virtually the same long position in certain securities with a few transactions.
Tax-loss selling enables investors to exit a position in a security and buy a corresponding one with similar exposure. By doing so, investors can potentially “harvest” capital losses while maintaining exposure to key long-term sectors.
“Tax loss is about the only silver lining you have in a bear market,” says Mark Noble, executive vice-president of ETF strategy with Horizons ETFs Management (Canada) Inc. in Toronto.
Under federal tax laws, investors who sell a particular stock, bond or fund to gain a tax loss must wait 30 days under the Canada Revenue Agency’s (CRA) “superficial tax loss” rule. The rule is inconvenient for those who want to maintain exposure to a specific security. (The strategy doesn’t apply to securities held within registered portfolios such as a tax-free savings account or registered retirement pension plan.)
Today, investors can easily satisfy the tax rule by buying a fund that is somewhat different than the one they just sold at a capital loss within their non-registered, taxable portfolios.
“A lot of index ETFs have a high correlation to each other,” Mr. Noble explains.
He provides the example of selling an S&P 500 index ETF at a loss and buying a different fund that offers a similar exposure, such as a large-cap ETF from a different fund provider, which he says “is effectively the same beta exposure.”
ETF holders also don’t miss out on potential gains during that 30-day period, which used to be a disincentive for tax-loss harvesting.
“You stay long that position, but you have harvested those losses to work to your advantage on a go-forward basis,” Mr. Noble says.
November and December are traditionally the months that investors carry out tax-loss selling. The losses can be applied against future capital gains indefinitely or carried back three years.
A recent National Bank of Canada Financial Markets report says investors might want to take advantage of the “historic” year of losses in both equity and fixed-income assets in 2022.
It notes that losses weren’t confined to individual stocks, with some major market indices down more than 10 per cent, “representing rare tax loss opportunities using broad market ETFs.”
The last day to recognize a capital loss in calendar 2022 is Dec. 28, so the trade can be settled before the year-end, National Bank states. However, investors may want to finalize trades even earlier to be sure.
ETF investors engaging in tax-loss selling, but wanting to maintain similar investment exposure, should be sure to use funds that track different indices to satisfy the tax-loss selling rules. National Bank notes two ETFs that track the same index “may be considered ‘identical property’ in the eyes of CRA.”
The current tax-harvesting season should also be a time for investors to take a second look at their portfolio strategy and perhaps rebalance their asset allocation, says Robb Engen, an advice-only financial planner who writes the Boomer & Echo personal finance blog.
“People that got a little overzealous in 2020-21 … maybe they jumped into thematic ETFs or maybe [went] too aggressive into tech and have actually seen bigger losses than the broader market,” the Lethbridge, Alta.-based financial planner says.
Mr. Engen, a big proponent of “all-in-one” balanced ETFs, notes tax-loss selling is relatively easy for an investor who might own a handful of funds versus a stock picker’s more cluttered portfolio.
“I have seen client portfolios with dozens and dozens of individual stock positions and going through line by line to see what the position is in terms of gain or loss,” he says, adding that tax-loss harvesting can be an “opportunity to simplify your holdings and maybe [make it] a little more diversified.”
The market downturn is a rare chance for investors heavily exposed to U.S. securities, which have enjoyed outsized gains for more than a decade, to lessen the capital gains hit on their taxable portfolios, Mr. Engen adds.
“Instead of working with that client to very slowly and methodically trim that taxable account over a period of years, maybe it is an opportunity to take a bigger bite and do some of that now,” he says.
The broad sell-off, which hit more sensitive sectors such as technology and real estate particularly hard, should also remind investors to keep risks lower inside their tax-sheltered portfolios.
“We generally say ‘don’t hold speculative investments, whether they are stocks or ETFs … inside your RRSP,’” says Scott Clayton, senior researcher at Toronto-based investment media company TSI Network.
“If you hold them in RRSP and they drop, you not only lose money on the investment, but you also lose the chance to get a tax loss.”