Tax-Loss Selling with Index Funds: Part 1

Now that we’re into December, many investors are turning their thoughts to skiing, holiday celebrations — and year-end taxes. If you’re investing in an RRSP, Tax-Free Savings Account, Registered Education Savings Plan (RESP), or other tax-sheltered account, you can ignore what follows. But if you’re a Couch Potato with a taxable account, you may be able to reduce the Canada Revenue Agency’s share of your investment returns with a strategy called tax-loss selling.

First, a primer on how capital gains are taxed. Any time you sell a security (a stock, bond or fund) at a profit in a taxable account, you trigger a capital gain. When you file your return, you need to report half of your capital gains as income, and you’ll pay tax on that amount. For example, suppose you put $10,000 into an ETF that is now valued at $17,000. Selling it would incur a $7,000 capital gain, and you’d have to report $3,500 in income on your return. If your marginal rate is 30%, that will cost you $1,225 in taxes.

The good news is that you can use capital losses to offset your gains. Let’s say in addition to your $7,000 capital gain you also sold a different ETF that had declined by $5,000. The CRA allows you to subtract the loss from the gain, so your net gain is just $2,000, dramatically reducing your tax bill. What’s more, you can “carry back” these losses to reduce capital gains tax you paid in the three previous years, or carry them forward indefinitely to reduce any future gains.

Avoiding superficial losses

The one important catch is that when you sell a security to claim a capital loss, you can’t buy it back for at least 30 days. If you do, it will be deemed a superficial loss and the CRA won’t let you use it to reduce your taxable gains.

If you’re a Couch Potato who uses broad-market ETFs, sitting on the sidelines for a month could have dramatic consequences: if you were out of the market this September or October, for example, you would have missed some very significant gains.

Fortunately, there is a way to harvest losses and stay invested at all times: you can sell an ETF that has declined in value and immediately replace it with another ETF in the same asset class. If you lost money with a US equity fund this year, you could sell the loser to lock in the loss, and then immediately buy a different ETF that also invests in US stocks. But before you do, make sure you understand the tax rules.

If funds track the same index, are they identical?

Here’s where things get controversial. The tax rules state that a superficial loss occurs when an investor sells and repurchases an identical property, which CRA defines as “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.”

This is pretty cut and dried when you’re talking about an individual company’s stock. If I sell Bank of Montreal, I can replace it with Royal Bank and the CRA would never question it. But what if I sell the iShares S&P 500 Index Fund (IVV) and replace it with the Vanguard S&P 500 (VOO)? Or if I replace the TD Canadian Index Fund with the RBC Canadian Index Fund, both of which track the S&P/TSX Composite? These are clearly different securities, but because they track the same index one might argue they are “the same in all material respects.” If you swapped one for the other, would the CRA call this a superficial loss?

It certainly could. In 2001, a CRA bulletin offered an interpretation of the rule as it applies to index funds:

“An investment in a TSE 300 index based mutual fund with a financial institution would, in our view, generally be considered identical to an investment in a TSE 300 based mutual fund of another financial institution.” (Note: TSE 300 is the former name of the S&P/TSX Composite.)

Yes, that was almost a decade ago, but in January 2008, Canadian Financial DIY contacted the Canada Revenue Agency and was told that nothing has changed. If that’s true, then selling IVV to buy VOO would indeed be considered a superficial loss, and so would selling TD’s Canadian Index Fund to buy RBC’s. If you exchange one for the other, your capital loss claim could be denied.

How can two competing funds be identical?

Tax experts have spoken out against the CRA’s interpretation. In Howard Atkinson’s 2005 book, The New Investment Frontier III, accountant Jamie Golombek is quoted as saying “I think CRA is wrong from a legal point of view because these are different legal entities. They can’t be identical.” More recently, in a Globe and Mail article published this September, Tim Cestnick writes:

“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.”

I’m no tax specialist, but I would add that if the two index funds in question have different fees it cannot be said that “a prospective buyer would not have a preference for one as opposed to another.” It’s also easy to prove that index funds with the same benchmark do not perform identically. I recently examined the last decade of returns for five funds that track the DEX Universe Bond Index, and in some years the tracking errors differed by more than 2%.

But as compelling as these arguments may be, CRA calls the shots. If you’re considering harvesting losses with ETFs that track the same index you’ll want to enlist the help of an accountant or tax advisor. You may be poking the lion in the cage.

The good news is that if you don’t want to get into an argument with CRA, there are ways index investors can harvest losses while staying comfortably within their target asset allocation and the tax code. We’ll look at some ideas in my next post.

The information in this post should in no way be considered tax advice for individuals. The rules around tax-loss selling are complicated and subject to interpretation. Always consult a qualified advisor before making any transaction for tax purposes.