Tax-Loss Selling with Index Funds: Part 2

In my previous post, I looked at the Canada Revenue Agency’s position on tax-loss selling with ETFs. According to the only CRA bulletin on the subject, if you sell an index fund or ETF and claim a capital loss, you must wait 30 days before repurchasing another fund that tracks the same index, even if the funds are from two different financial institutions. Otherwise, the sale will be considered a superficial loss, and you won’t be able to use it to reduce your taxable capital gains.

There are many reasons why this might be called unfair: two funds that track the same benchmark may have different fees and slightly different holdings, and they certainly can’t be expected to perform exactly the same. But whether we like it or not, the CRA considers them identical property, and investors who ignore that interpretation risk having their capital loss claim denied.

If you’re a Couch Potato who’s looking to harvest some losses in a non-registered account, your goal is to stay within the CRA’s rules while also keeping your market exposure as consistent as possible. You can do that by identifying pairs of ETFs or index funds that track distinct but highly correlated indexes. Here are some suggestions:

Go big or go broad. Large-cap indexes such as the S&P/TSX 60 in Canada, or the S&P 500 in the US, are closely correlated with total-market indexes such as the S&P/TSX Composite, or the Russell 3000. A Canadian equity investor can safely substitute the large-cap XIU with the broad-market XIC and expect very similar performance. (If you use index mutual funds, note that the Altamira Canadian Index Fund tracks the S&P/TSX 60, while almost all of its competitors track the S&P/TSX Composite.) Funds that track the S&P 500 (including IVV, SPY and VOO) can be replaced with total-market ETFs such as VTI or IWV.

Switch to a competitor’s product. The four Canadian ETF providers have many products that cover the same asset classes with different indexes. The BMO Dow Jones Canada Titans 60 (ZCN) is a virtual clone of the S&P/TSX 60. In fixed-income, iShares’ XBB, Claymore’s CAB and BMO’s ZAG all cover the broad Canadian bond market. BMO also offers a real-return bond fund (ZRR) and a REIT fund (ZRE) that overlap with their iShares counterparts (XRB and XRE, respectively). Just make sure you compare the specific holdings, as names can be deceiving: the Claymore and iShares Canadian dividend ETFs, for example, are very different.

Get stylish. Sometimes a “style index” will have very similar holdings to traditional index. The most popular Europe-Pacific index funds — VEA, EFA, XIN, and all the bank-sponsored international index funds — track the MSCI EAFE Index and could be considered “identical properties.” The iShares MSCI EAFE Value Index Fund (EFV) has many of the same top holdings and is a reasonable substitute.

Consider derivative-based ETFs. The new index-tracking ETFs from Horizons BetaPro are a grey area. These are based on the S&P/TSX 60 (HXT) and the S&P 500 (HXS), but rather than holding the stocks directly, they use a total return swap, which is a type of derivative. These innovative products will behave quite differently in taxable accounts (they are more tax-efficient), so it’s hard to see how they could be considered “identical” to XIU and XSP, even if they track the same indexes. But this is uncharted territory: make sure you speak to a tax advisor before you make your decision.

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.