Is it time for tax loss selling?

Last October, Justin Bender and I published a white paper on tax loss selling with ETFs. It explained how index investors can harvest capital losses while maintaining a consistent exposure to the equity markets. We were proud of the paper (which was even adapted as a continuing education course for advisers) but it proved to be rather useless during the subsequent year. Indeed, it would have been irrelevant during much of the last three years, as the charging bull market never stopped to catch its breath. There were simply no capital losses to harvest.

Well, it may be time to dust off the paper. September has been a difficult month for stocks, especially in Canada, and investors with large portfolios might now have their first tax loss selling opportunity since 2011.

No gain, no pain

Let’s start with a refresher on how tax loss selling works. In a non-registered account, when you a sell a security that has declined in value, you realize a capital loss. You can use these to offset any capital gains you’ve incurred in the current year, which can reduce your tax bill. Moreover, unused losses can be carried back up to three years, or carried forward indefinitely to offset future capital gains.

As we explain in our white paper, ETF investors can take advantage of market downturns by selling a fund that’s showing a significant loss. Then they can immediately repurchase a similar but not identical ETF to avoid the superficial loss rule. This allows them to reap the tax benefit without meaningfully changing their market exposure.

Wake me up when September ends

PWL Capital recently adapted its portfolio management software to automatically identify these tax loss selling opportunities in client accounts. Justin asked the programmers to use Larry Swedroe’s rule of thumb, which says a security should only be sold when the loss is at least 5% and at least $5,000. For months the software generated blank reports as markets continued to rise. But this week it finally flagged a few accounts: they were new clients who bought their Canadian equity holdings only recently.

Consider the Vanguard FTSE Canada All Cap (VCN): it closed at $31.56 per unit on Sept. 2, and by the 25th it had fallen to $29.97, a decline of just over 5%. A client who had purchased at least $100,000 of this ETF at the beginning of the month would now satisfy both of Swedroe’s criteria.

So, if you’re in this predicament, should you immediately sell VCN and buy a replacement? (In this case, you could use the iShares Core S&P/TSX Capped Composite (XIC) or the BMO S&P/TSX Capped Composite (ZCN).) Not necessarily. I asked Justin to explain how he handled the decision for our clients:

1. The first step, he says, is to check whether you have crystallized any capital gains this year (or if you plan to realize any before the year is out). If so, any harvested loss would offset these first.

2. Next, check whether you realized any capital gains during the previous three years.

3. Now consider your marginal tax rate. If your capital gains were realized during a year when you had a low income, you may not have paid much tax: for example, an Ontario resident with an income of $30,000 would pay just 10% tax on an additional $5,000 of capital gains. This investor has less incentive to carry back losses than a high-income earner whose gains were taxed at 24%.

4. Finally, consider whether you already have net capital losses carried forward from previous years. You can do this by checking your Notice of Assessment or the CRA website. (If your adviser is making these decisions, you can complete a T1013 form to allow him or her to check this information for you.)

After working through these steps with two clients, Justin arrived at different decisions. In the first case, he decided to harvest the loss for a client in a relatively high tax bracket who had $3,500 in capital gains from this year and last. But the second client already had large carried-forward losses from previous years, so Justin felt harvesting another $5,000 wasn’t worth the cost.

If you use a tax loss selling strategy, it’s important to track your results so you can see whether you added value after costs. It’s possible, for example, that your replacement fund will go on to lag the original and undo your hard work. There are no guarantees with tax loss selling, but if you follow a disciplined strategy like the one we’ve outlined here, it offers the potential for significant savings.

Dan Bortolotti is the consulting editor of MoneySense. He blogs here and at canadiancouchpotato.com. Find him on Twitter @CdnCouchPotato.