After a bad loss, a coach or player may talk about a moral victory, trying to turn a negative result into a victory. The tax and investment equivalent is tax-loss selling: realizing capital losses and using them to “win” tax savings.
The goal of tax-loss sales in taxable investment accounts is to realize the capital loss before the end of the calendar year. If capital gains were realized earlier in the same calendar year, they are reduced by capital losses. If realized losses equal realized gains, the investor does not have to pay capital gains tax. If current year capital losses are greater than capital gains, they can be carried forward for up to three years to offset capital gains or carried forward indefinitely to offset future capital gains.
How do I carry capital losses backwards or forwards?
For tax year 2022, the three capital loss carryback years will be 2019, 2020, or 2021. To carry forward capital losses, you must complete Form T1A, Application for Transfer of Loss and attach it to your 2022 tax return. To apply net capital losses from other years to your taxable capital gains in 2022, file your deduction claim on line 25300.
Carrying forward capital losses may be beneficial because the client is already benefiting from tax savings. If a client expects to be in the same or lower tax bracket in the future, capital loss carryforwards may generate greater tax savings. Furthermore, as this is a three-year period, carrying forward to the oldest year first ensures that the client does not lose out on tax savings made in that year.
However, a client who expects to be in a higher tax bracket in the future may wish to carry forward capital losses, especially if he or she plans to sell securities that are likely to result in a capital gain. While this means sacrificing the certainty of incurring capital losses, the expected tax savings in the future may be worth the risk.
What’s the catch?
Principles of superficial loss. If a capital loss is deemed superficial, it cannot be used to offset realized capital gains. Instead, the loss is added to the adjusted cost basis (ACB) of the identical property. For a capital loss not to be considered superficial, the customer or related person must:
- not purchase an identical property for 30 calendar days before and after the sale settlement date, and;
- not continue to be the owner of an identical property within 30 calendar days from the settlement date of the sale (61 days in total, including the settlement date).
A related person includes the client or his or her spouse, corporations and partnerships controlled by the client or his or her spouse, and trusts in which the client or his or her spouse are the majority beneficiary. Such trusts may include RRSPs, RRIFs, TFSAs and RESPs where the subscriber is the client or his or her spouse.
The identical property may be the exact same security or the same as the security sold by the client in all material respects; for example, an ETF that tracks the same index, even if it is from a different manufacturer.
Earnings-tested benefits
Applying net capital losses from other years to this year or carrying forward losses from previous years will not affect the amounts to which you are entitled under means-tested benefits. The reason is that net capital losses for the remaining years (line 25300) are subtracted from net income before adjustments (line 23400) and net income (line 23600). However, current year capital losses will reduce or eliminate taxable capital gains reported on line 12700, and this will reduce the amounts reported on lines 23400 and 23600, helping to preserve the amounts of related benefits.
Net income before adjustments is used to calculate amounts such as pension security repayment, employment insurance repayment and Canadian recovery benefit repayment. Net income is used to calculate non-refundable tax credits at the federal and provincial levels. This includes, but is not limited to, Canada Child Benefit, GST/HST Supplement, and Age Quota.
In other words, using net capital losses from other years to reduce net capital gains will not reduce returns to benefits such as OAS or increase the amounts you receive from benefits such as the Canada Child Benefit.
Similarly, for corporations with income from passive investments that wish to reduce their adjusted aggregate investment income (AAII), capital losses for the current year will reduce the taxable capital gains included in this calculation. However, capital losses from other years will not. This is important because passive income earned from a corporation can lower the corporation’s small business deduction (SBD). This reduction begins when a corporation (or group of related corporations) earns $50,000 in passive income in a year. SBD will be completely eliminated once passive income reaches $150,000. For every dollar of passive income over $50,000, your SBD will be reduced by $5.
Before becoming aware of capital losses in a corporation, clients should consider checking the current capital dividend account (CDA) balance. If the balance is positive, they may consider paying a tax-free capital dividend to shareholders before realizing capital losses. Otherwise, half of the realized capital loss will reduce the positive CDA balance and reduce the amount of tax-free money that can now be distributed to shareholders.
If the realization of capital losses results in a negative CDA balance, the tax-free capital dividend cannot be paid until the balance is positive, for example if future capital gains are realized.
What about cryptocurrencies?
It has been a difficult year for cryptocurrencies, and clients may face unrealized losses in their cryptocurrency portfolios. However, the rules are not simple when it comes to cryptocurrencies.
If a taxpayer’s cryptocurrency transactions are capital in nature, the gains or losses from such transactions constitute capital gains or losses. In such circumstances, realized capital losses from cryptocurrency transactions can be used to offset realized capital gains from the sale of securities such as stocks, ETFs, mutual funds or segregated fund contracts.
This is different from income account transactions – which are seen as running a business – or barter transactions, which are used to purchase goods and services. Transactions in the income account constitute fully taxable income, while the tax consequences of barter transactions are the same as if the transaction had been made in ordinary currency.
summary
Tax-loss selling is a way to cover losses and turn them into tax-saving benefits. It may be easier to find losses in a taxable portfolio in volatile markets than in strong bull markets. Be sure to help clients balance their short-term tax savings decision with their long-term portfolio goals.
Curtis Davis, FCSI, CFP, TEP, is Director of Tax Services, Retirement & Estate Planning and Retail Markets at Manulife Investment Management
