Capitalize on investment losses

When markets aren’t offering much opportunity to make money, it’s a good time to enact a tax loss selling strategy and lighten your tax burden.

Tax-loss harvesting is simple: you deliberately sell securities at a loss to realize capital losses. Net capital losses are calculated exactly the same way as net capital gains. Fifty percent of the net capital loss is eligible to be used as a potential deduction when filing your tax return.

Like other investors, you may be hesitant to sell securities at a loss, but that hesitation could result in a missed upside opportunity.

A capital loss can be:

• used to offset capital gains from the previous three years;
• used in the current tax year; or
• carried forward indefinitely to offset any future capital gains.

Sell the stock, buy the index

ETFs can be used to maintain broad market or sector exposure while harvesting tax losses from individual equity positions.

Index-tracking ETFs typically offer a high degree of equivalent market beta to mutual funds or stocks. So you could sell any of those securities at a capital loss for tax purposes, if applicable, to offset capital gains from the previous three years, or apply to current or future gains.

You could then purchase an ETF that invests in the same or similar asset class—or even the same index with a similar risk and return profile and correlation to the original security.That way, you can harness capital losses to reduce taxable income while maintaining market exposure when prices are anticipated to rise.

Here’s how it works. Note, this example is from 2011, but the theory still applies.

Capital-loss harvesting on RIM

Here’s an example of the principles in motion. In 2011, Reasearch in Motion, lost a lot of value. It was down more than 65% on a three-year basis, ending November 30, 2011, and fell even further in December. However, at the time the stock still constituted nearly 15% of the S&P/TSX Capped Information Technology Index Fund (XIT).

RIM’s correlation to the S&P/TSX Capped Information Technology Index has been 0.717 over the three-year period ending November 30, 2011. Again, you could sell RIM, harvest the losses, and buy XIT to maintain exposure to RIM without being subject to superficial tax-loss rules.

Almost every equity strategy, whether it involves stocks or mutual funds, probably has a comparable ETF alternative listed on the TSX that can give you a similar market exposure, or beta, as the original security.

Keep in mind the last day for tax-loss selling for Canadian-listed stocks is three days before the last business day of the year. Of course, this strategy can be used throughout the year to harvest losses.

Howard Atkinson, CFA, CIMA, ICD.D, is president of Horizons Exchange Traded Funds.