Tax Loss Harvesting with ETFs – A Tax Deferral Strategy

With the year end approaching, I wanted to touch on the concept of Tax Loss Harvesting and how it can be beneficial for increasing after-tax wealth.

 What Is Tax Loss Harvesting

Tax loss harvesting involves selling investments that have lost value to capture the loss for tax benefits and purchasing another similar investment to maintain the exposure to the market, then repurchasing the original investment at a later date if desired, within the rules of the Canada Revenue Agency (CRA).  The loss captured can be applied to any capital gains in the current year or to any capital gains in the last 3 years.  Alternatively, the loss can be carried forward indefinitely to offset future capital gains.  Net result is we get to keep more cash in our pocket for now than we otherwise would have.  Think of it as getting an interest free loan from the government.

Stated differently, harvesting losses “…provides a tax-free way to realize capital gains on winning investments.” [Source: Private Wealth Management: A Review; The Research Foundation of CFA Institute Literature Review ]

Registered accounts (such as RRSPs, RRIFs, TFSAs, etc) are not eligible for tax loss harvesting; we can only do this in taxable accounts.

 How Does It Work

Let’s walk through a hypothetical example, suppose:

-> you own the ETF XIU – S&P/TSX 60 Index Fund investment (tracks the S&P®/TSX® 60 Index) that is down $3000 nearing the end of the year (but not sold – ie, an unrealized loss).

-> you have also sold another investment during the year where you’ve had a net gain of $3000 (ie, a realized gain).

-> your capital gains tax rate is 20%

If you don’t take advantage of tax loss harvesting, you would have to pay tax of $600 (20% x $3000) on your realized gain of $3000, and you have an investment that is down $3000 on paper.

Now, let’s say, we decide to take advantage of this strategy.  In order to do so, we would have to sell XIU at a $3000 loss to realize the loss in order to be able to offset other gains against it.

In this example, you now have a real, realized $3000 loss with XIU (not just a paper loss) which can be used to offset the $3000 gain.  You have a net gain of $0 so you now avoid paying the $600 tax (for now).  The intention is that you will repurchase XIU after 30 days, eventually recoup the losses down the road if the investment rises again.  Recouping the losses will then give you a $3000 capital gain (since you are now up $3000 from the time you re-bought XIU), and would pay the tax at a later date.  You have essentially deferred paying the $600 in tax.  Paying tax later is better than paying tax now!  By paying the tax later, you can take the $600 saving and invest it,  get to keep the gains from the investment, and then repay the $600 in tax to the government at a later date when you realize the gains by selling your investment.

Here are the steps you need to follow to accomplish this strategy:

  1.  Sell the investment/ETF that currently losing money
  2. Find a replacement investment/ETF that is similar to the investment /ETF you sold, assuming you still want to maintain a similar market exposure.  See the section below on finding replacement ETFs for more details
  3. In the new year, and after more than 30 days has elapsed since the initial investment was sold, re-purchase the old investment and sell the replacement investment (unless you are happy with the replacement investment, in which case, skip this step).

 Finding a Replacement ETF

The purpose of finding a replacement ETF is you want to maintain your exposure to the market while executing this strategy, assuming you still believe the market will be going up.  Make sure the replacement ETF does not track the same index as the one sold, as CRA may have a problem allowing you to claim the loss in the first place if they think you have generated a superficial loss.

Steps;

  1.  Find a replacement ETF by reviewing products offered by all the ETF providers
  2. (Optional) Use the fund comparison tool in the URL below to check the correlation of the replacement ETF with the original ETF.  The closer the correlation is to 1.0, the more similar the fund is.

Fund Comparison Tool: http://www.claymoreinvestments.ca/advisor/fund-comparison

In the example above, suppose we decided to use CRQ as our replacement ETF for XIU.  Using the Fund Comparison tool, we get a table like the one below that shows the correlation between CRQ and XIU.  From the table, we can see the correlation of ‘1 – CRQ’ with ‘2 – XIU’ is 0.94 (pretty close to 1).  We can be comfortable using CRQ as a replacement as their return performance will be pretty similar and each of these ETFs tracks a different index.

Strategy 1 2
1 – CRQ –  iShares Canadian Fundamental Index Index Fund Common Class 1.00 0.94
2 – XIU – iShares S&P/TSX 60 Index Fund 0.94 1.00

When Should You do It

You should take advantage of tax loss harvesting if the present value of the tax benefit outweighs the trading costs.

The longer you plan to hold the investments, the more advantageous the harvesting technique will prove to be.  In the example above, the $600 dollars of tax that was saved can be invested for gains.  The longer you can invest the $600 and take advantage of the “interest free loan” from the government, the more effective this strategy becomes.

 Things To Look Out For

  • Sell the investment(s) you want to trigger the loss for before the tax deadline
  • Be wary of creating a superficial loss (See CRA’s site for additional details)
    • Avoid re-purchasing the security within 30 days of selling it
    • For the replacement purchase, avoid an ETF that tracks the exact same index.  Instead, look for an ETF that tracks a similar, but not the same index
    • Consult a tax professional to make sure your actions are not violating the superficial loss rules

Disclaimer
The contents in this post and site are not to be taken as advice.  Please consult your tax professional and/or advisor before taking action.

Advertisements

Comments Or Questions?

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s