Capital losses, tax loss harvesting, and the superficial loss rules

Making effective use of capital losses

Just as an appreciation in price can lead to a capital gain, a decrease in price can result in a capital loss. In an investment portfolio, capital gains and losses may apply to individual securities or to pooled securities like mutual funds. For the purposes of this article, we’ll use the term “security” as a short form reference to both.

As with capital gains, capital losses are unrealized until there is a taxable event. Half of the capital loss, known as the allowable capital loss, can be applied to offset the taxable half of capital gains.

Applying capital losses

Capital losses realized in a year must first be used against capital gains that same year, with the investor then having discretion to apply any unused excess against capital gains in any of the three preceding tax years, or to carry those losses forward for future use.

For an investor who realized and reported capital gains in 2021, then 2024 is the last year to carry capital losses back and amend/re-file that earlier tax return to recover the tax paid on those capital gains.

Verifying and using your capital loss carryover

If you anticipate realizing on capital gains in the current year and have unused capital losses from past years, you may make use of that loss carryover now. You can find your carryover balance on your latest Notice of Assessment, or by logging into your My Account on the Canada Revenue Agency website, and viewing “Carryover amounts” under the “Tax returns” tab.

Candidate securities for ‘tax loss harvesting’

Look at your current non-registered account holdings to see if you have any securities in a loss position. You can sell a portion of those to realize sufficient capital losses to offset some or all of the capital gains in the current year, with the option to carry any excess back to any of the three preceding years. Depending on investor circumstances, a capital gain may be anticipated in a near future year, in which case there is the option to trigger a current loss to be applied against the future capital gain (assuming it comes about) in that later year.

To be clear, the tax impact contributes into your decision, but should not dictate your portfolio actions.

It may be the case that the currently-held securities still fit an investor’s longer term portfolio goals despite being in a loss position at present. After the securities are sold, the investor may be concerned about missing out on a price recovery of those disposed securities, which may make it may be tempting to immediately re-establish the position after triggering a capital loss. However, if the investor acts too quickly, there is a risk of being caught by the superficial loss rules in the Income Tax Act (ITA).

Superficial loss rules

These rules apply if the same security is purchased in the 30 days before or 30 days after the loss transaction. This extends beyond the investor personally to affiliated persons, including a spouse and registered plans belonging to either of them, such as a RRSP, RRIF, TFSA, RESP or RDSP. It may also apply to corporations or trusts of which either is a significant shareholder or beneficiary, respectively.

The mechanics of the rule is that the capital loss is denied on the sale transaction, but an equivalent amount is added to the adjusted cost base (ACB) of the new holding on the purchase side. Thus, the capital loss is embedded into the new holding and remains available for the holder to use in future, but cannot be used against capital gains arising presently.

An important exception to the application of the ACB addition on the purchase transaction is where a registered account is involved. The first half of the superficial loss mechanics will still apply to deny the capital loss, but there will be no corresponding addition to the ACB in the registered account. The capital loss is effectively permanently lost. This is true whether there are two distinct transactions, or where there is an in-kind transfer of securities from a non-registered account into a registered account.

Importing losses of a spouse

There is a way to use the superficial loss rules to strategically transfer a loss from one spouse to the other. Let’s say you have capital gains, while your spouse has unrelated securities in a loss position.

- Your spouse sells and realizes a capital loss, and you purchase the same security in the +30/-30 day window.
- Your ACB will be higher than your purchase price by the amount of the added loss denied to your spouse.
- After waiting at least 30 days following your spouse’s settlement date (which is 2 days after the transaction date), you can sell to realize your loss, and use it against current capital gains in the usual manner.

Of course, the price of your new securities could rise during your holding period, reducing your expected loss. But that means you receive more money when you sell, so there’s not much to complain about under that scenario.

Settling transactions before year-end

The relevant date for capital gain or capital loss recognition is the settlement date. Beginning in 1995, the settlement day was three days following the trade date. It was reduced to two days in 2017, and as of May 27, 2024, Canada moves to one-day settlement, or T+1. For 2024 recognition, a sale on Monday, December 30 will settle the following day, Tuesday, December 31, the last business day of the year.

Donating securities ‘in-kind’ to charity

Tax-optimizing your philanthropy

When it comes to charitable donations, the most likely type of donation that comes to mind for most of is cash. However, there are a variety of ways to support your favourite charitable causes, one of which is to donate publicly traded securities in-kind.

The Canada Revenue Agency (CRA) defines a publicly traded security to include a share, debt obligation or right listed on a designated stock exchange, a share of the capital stock of a mutual fund corporation, a unit of a mutual fund trust, an interest in a related segregated fund trust or a prescribed debt obligation.

When such securities are donated in-kind from a non-registered account, a tax receipt is issued for their fair market value (FMV) on the donation date. As with cash donations, a tax credit can then be claimed to reduce your income tax bill. In addition, in-kind donations can cost you less, and there is no reduction in what the charity receives.

How the donation tax credit works

When you make charitable donations, both the federal and provincial governments allow you to claim a credit against the income tax you owe. The tax credit is based on the total dollar value of all donations in the year, no matter how many individual donations you make. The value of the credit varies by province, with the credit rate ranging from 20% to 25% on your first $200 of annual donations, and 40% to 54% on the amount over $200.

You can claim donations up to 75% of your net income in a year. Donations not claimed in the current year can be carried forward to be used in any of the next five years. This assures that a large single donation can be fully utilized, even if it exceeds the net income threshold. As well, this gives you flexibility if it is more beneficial to forego claiming the entire credit in the current year, and instead strategically spread it across multiple years.

For more on the principles of the donation tax credit, see the article Four tax strategies to get more bang for your charitable donation buck.

Donating cash or selling appreciated securities?

Most people make periodic charitable donations in cash, but that may not be optimal when you own securities that have appreciated in value. Cash is worth what you have in your hands, but appreciated securities carry a waiting tax bill. More specifically, in the 2024 Federal Budget the income inclusion rate for capital gains was increased to 2/3, but the prevailing 1/2 rate remains available for individuals on the first $250,000 of capital gains in any year. For trusts and corporations, the 2/3 rate applies to all capital gains. The 1/2 rate is used in the examples in this article.

Let’s say you want to contribute to a local charity’s capital fund, and you have equal balances in your chequing account and your (appreciated) securities account. If you write a cheque, you still have your securities, but with their pending tax liability. If you sell the securities to make the donation, there is less money available for the donation due to the tax, which means that either the charity gets less, or you need to top up the donation from your chequing account.

One way or another, you or the charity will bear the brunt of the tax in these two scenarios. The question is whether there is a way for you to keep your fully spendable chequing balance, while making the maximum donation to the charity using your securities? This is where in-kind donations come in.

Donating securities in-kind to eliminate tax on capital gains

Typically, when there is a change of ownership of a security, a disposition is deemed to occur, and a capital gain or capital loss is triggered. However, when a security is transferred directly to a registered charity as a donation, the tax on any capital gain is reduced to zero. We can illustrate this with the following example:

- Donor is in a 40% combined federal-provincial tax bracket in a province with a top donation credit rate of 50%
- $10,000 donation, using a security with $10,000 FMV and $6,000 adjusted cost base (ACB)
- There has already been $200 in charitable donations made elsewhere this year

Donating securities in-kind to trigger a capital loss

The donation of appreciated securities is attractive, as we have just outlined. However, donating depreciated securities can also be a viable option, especially when it comes to your year-end tax planning.

When you donate depreciated securities, you trigger a capital loss that will be applied against capital gains realized in that same tax year. You can then carry back any remaining capital loss to offset capital gains in the three previous tax years or carry those losses forward indefinitely. So not only will you receive a tax credit for the FMV of the donated securities, you will also be reducing your tax bill if you have realized capital gains elsewhere.

Interest equivalency

A tax tool for comparing interest to other investment returns

Rate of return on a portfolio is often front and centre in an investor’s mind. Understandable as this is, ultimately it’s about how much of those returns the investor will keep. The difference between the two is tax, which in turn depends on the type of income earned and the investor’s tax bracket.

This article deals with an individual earning income in a non-registered account, also known as an open account or cash account. With a range of variables in play, it can be difficult to follow the steps from initial return through tax calculation to spendable after-tax cash. A useful tool to help connect the arithmetic is interest equivalency.

Interest – Taking into consideration the tax trade-off

Interest is appealing for the part of a portfolio where certainty is the prime concern. For example, the issuer of a guaranteed investment certificate (GIC), agrees to pay a set amount of interest for the period of the contract.

This certainly provides valuable comfort to the investor, but an important trade-off from a tax perspective is that interest faces the full tax rate at any given income bracket.

Preferred taxation – Capital gains & Canadian dividends

Compared to interest, Canadian dividends and capital gains receive favourable tax treatment. They come at it from different routes, with the benefits emphasized at different income levels. Canadian dividends provide the best after-tax yield at low to mid brackets, giving way to capital gains at higher and top brackets.

Capital gains

There are two features that lead to the favourable tax experience from capital gains:

1. Deferral – While a security is held, no tax arises on changes in its price. This is also true if the investor holds a mutual fund that fluctuates according to price movement of its underlying securities. But a redemption/sale is a taxable event, and if the value has increased then the investor will realize a capital gain at that time.
2. Reduced inclusion rate – When there is a disposition, capital gains are said to be realized in that year, but only a portion of the capital gain is taxable. The “taxable capital gain” is derived by applying the income inclusion rate, which has ranged between 1/2 and 3/4 since 1971, but has been stable at 1/2 since 2000. The 2024 Federal Budget increased it to 2/3, while still allowing the 1/2 rate on the first $250,000 of an individual’s annual capital gains. (For trusts and corporations, the 2/3 rate applies to all capital gains.) The 1/2 rate is used in the examples to follow, on the assumption that the investor is an individual with less than $250,000 of annual capital gains.

The first feature allows tax-deferred growth. It is the second that is used in the interest equivalency calculation.

Canadian dividends

Like interest, Canadian dividends are taxed in the year earned, but the tax is calculated in two steps:

1. Gross-up – The ‘gross-up’ factor adds back the corporate tax, so the investor’s bracket can be used to calculate the tax as if the investor had earned the income that was really earned by the corporation.
2. Tax credit – The investor then gets a tax credit for the tax that the corporation has already paid.

This two-step process protects against double-taxation. The government’s revenue is split between the corporate tax and the personal tax, which is why an investor pays less on a dividend compared to the full rate for interest.

How interest equivalency works

Interest equivalency shows what amount of preferred income will give an investor the same after-tax spendable cash as a dollar of interest. Alternatively, it can be expressed as the higher amount of interest that equates to a dollar of preferred income. Either way, the result is expressed in dollars and cents.

Formula

Interest equivalency is shown in the following table at top tax bracket for each province, but it can be calculated at any income level by applying the following formula that uses marginal tax rates (MTR):

Interest equivalency = ( 1 – MTR^interest ) ÷ ( 1 – MTR^preferred )

Proof

It may be easier to see how this works by looking at an example, here using Alberta in the first row of the table:

Informing yourself with this tool

To be clear, interest equivalency is a tool used to compare investment returns; it is not a suggestion against interest returns in a portfolio. All income types have their respective features, benefits and risks. The tool can help advisors and investors understand, compare and discuss investment options and recommendations in a portfolio.