Tax-loss selling: Superficial loss and identical property rules

Many clients (and their tax preparers) are working diligently to file their tax returns. As part of that process, many are reviewing their taxable dispositions for the past year as well as T3 and T5 tax slips for taxable distributions. Some will find that they owe taxes on capital gains for 2022 despite a challenging market, which is possible if securities are sold (either directly, or indirectly via mutual funds or ETFs) at a fair market value that exceeds the adjusted cost base (ACB).

When this occurs, taxpayers often look for opportunities to reduce the impact of their taxable capital gains, and quite often turn to tax-loss selling (though it is too late to trigger capital losses for the 2022 tax year to offset capital gains for the same year).

To recap, tax-loss selling is a strategy to make use of capital losses in the non-registered environment. The losses can be used to offset capital gains realized elsewhere in a portfolio, and, to the extent that capital losses exceed capital gains in a year, the net capital loss can be used to offset capital gains in any of the three previous tax years or carried forward for use in any future year. The Canada Revenue Agency (CRA) form T1A Request for Loss Carryback is used to carry capital losses back to a prior year.

There is a potential challenge with this strategy; realizing a capital loss can mean selling a security that plays an important role in your portfolio. Certain investments, such as traditional mutual funds and ETFs, can be used to maintain exposure to a particular asset class while allowing for claimable capital losses.

To implement a tax-loss selling strategy, an investor would trigger a capital loss¹ by selling an individual security, mutual fund or ETF that has declined in value. If the investor wants to remain invested in the market, they would subsequently acquire a different yet similar security, mutual fund or ETF. Importantly, though, if the investor wants to claim the capital loss, they should be careful not to acquire a security that is identical to the security sold. Otherwise, the ITA’s superficial loss rule will apply, denying the capital loss claim.

What is a superficial loss?

Where an investor or an “affiliated” person sells a security or fund that has depreciated in value and acquires the same security or fund — identical property — 30 days before or 30 days after the sale, the loss would be deemed superficial and denied for tax reporting purposes. Affiliated persons for purposes of this rule normally include the taxpayer’s spouse, common-law partner, RRSP, RRIF and TFSA, as well as other corporate, partnership and trust relationships.

The loss would be added to the ACB of the repurchased investment, deferring use of the capital loss until the repurchased investment is sold. The purpose of the rule is to prevent investors from triggering capital losses for tax reasons without a real intention to dispose of the investment.

What is identical property?

When it comes to the superficial loss rule, the CRA takes a “question of fact” approach to determine if two properties are identical. In other words, the CRA looks at the details of the particular case and forms an opinion based on the facts.

With regards to the sale and purchase of traditional mutual funds and ETFs, if the underlying investments for two funds are not identical, it is likely that the sold and purchased funds would not be considered identical properties, and thus, no superficial loss. If the underlying securities are identical, the superficial loss rule may apply. The CRA has defined identical properties as “properties which are the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another.”²

In a technical interpretation document, the CRA notes that while a TSE 300 index fund, for example, would generally not be considered identical to a TSE 60 index fund, two TSE 300 index-based mutual funds from different financial institutions would generally be considered identical.

It is often possible to trigger a capital loss while maintaining exposure to a particular sector or asset class by switching between different fund structures (e.g., traditional mutual fund to ETF or vice versa). This is, in part, because of differences in the fund structures that could cause an investor to prefer one versus the other.³ The argument against a superficial loss would be even stronger where the underlying securities are not identical. Similarly, switching between different mutual funds or different ETFs with similar (but not identical) exposure would likely achieve the same result, especially where the products follow different benchmarks.

Consider the following example.

Cliff purchased 3,000 shares of ABC Emerging Markets ETF on Aug. 10 for $30,000 ($10 per share). Thinking about capital-loss planning, on Oct. 11, Cliff sold all shares of the fund for proceeds of $24,000 ($8 per share), resulting in a capital loss of $6,000. Wanting to continue to participate in the emerging markets sector, three days later, on Oct. 14, Cliff bought 3,000 shares of XYZ Emerging Markets Plus ETF at $9 per share and continued to hold the shares for the remainder of the year.

Because Cliff replaced one emerging markets ETF with another, he was able to maintain exposure to the sector. And, because the two ETFs have similar but different underlying securities, they are not identical for purposes of the superficial loss rule.

Also of note, capital losses triggered by transferring securities from a non-registered account directly to an RRSP or TFSA would be denied under a separate stop-loss rule.⁴ To avoid this rule, investors can trigger the loss by switching to a different security in the non-registered account and follow with a contribution to the RRSP or TFSA. The investor should then wait 31 days from the time of the original sale before reacquiring the original security within the RRSP or TFSA. For more on this topic, see one of my previous columns.

Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning with CI Global Asset Management. Wilmot can be contacted at wgeorge@ci.com.

Notes

1 Assumes the investment is held on capital account. If the investment is held for business purposes, business income or losses would normally result.

2 Interpretation bulletin #IT-387R2

3 If engaging in this strategy, check with the product issuer to ensure that the fund structures are different and not simply different purchase options of the same structure.

4 Section 40(2)(g)(iv) of the federal Income Tax Act

Wilmot George

Tax & Estate

Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning at CI Global Asset Management. Wilmot can be contacted at wgeorge@ci.com.