The bad news is in, and the equity markets are up, but still down from two years ago this fall. Investors are reeling from constant negative news, and are deeply concerned about the general state of the economy. Some of these fears are well founded, as the world economy is going through a period where it de-leverages its market positions, and the effects will likely be a sustained global recession. But, the prudent investor will remember that the markets will go up again, but it is still difficult to endure a portfolio loss. It will take time to recover, but they will.
However, there is some immediate opportunity to be found, and it is not dependent on the markets. The best way to make money right now is to take it from the taxman. Since portfolios are generally down, you might want to take advantage of a concept known as “tax-loss harvesting.”
What is it?
Tax loss harvesting is the process of triggering capital losses to realize an immediate tax gain. In the case where you trigger a loss in your portfolio, you have two options.
First, you can use capital losses to carry back against capital gains tax payable in 3 previous years. So, if you have capital gains that you have paid recently, you can trigger capital losses and reclaim the taxes you have paid in the past. At the highest marginal rate, this can mean that your current losing investments are worth as much as 23 cents for every dollar they have gone down.
Second, you can trigger capital losses and carry them forward indefinitely. This means that you can “bank” a specific amount of capital losses and carry them forward to use against capital gains that you may have in the future. This will allow you the flexibility to re-allocate portfolios in the future while limiting the taxes triggered upon disposition, or it could allow you the ability to take tax-free income from a portfolio through dispositions rather than through income or dividends.
How does it work?
Tax-loss harvesting can only be done in a non-registered, or taxable, account. Transactions as described below will not work with assets held within a registered plan because you are not subject to tax on growth, and conversely, you are not able to take a benefit from capital losses.
Essentially, the point is to arrange a transaction to sell-out a position that is sitting with a significant drop in value, and then repurchase a similar holding in the same asset class. This creates a loss, but maintains the desired asset class exposure so you don’t miss any potential upside.
In Canada, according to tax law, in order to take the capital loss, you must not reinvest in the same security for a period of 30 days. So, assuming that you wish to stay invested, you do not want to be out of the market for a period of 30 days, specifically with markets as volatile as they are today. This is why you sell one holding and purchase another similar one.
Mutual Fund Holders
So, let’s take for example that your portfolio holding, the XYZ Canadian Equity Fund, is down 25%. The original cost of the funds was $100,000 – this is referred to as the “cost base.” If you were to sell that fund right now, you would incur a $25,000 loss. At the highest tax rate, this loss is be worth approximately $5,800 of taxes, either to be reclaimed from past taxes paid, or taxes payable in the future.
If you were to simply sell the fund and take the loss, you would have crystallized your loss, and if the market turned around, you would miss your gain on the upside. Instead, you can sell the XYZ Canadian Equity Fund (“harvesting” your loss), and repurchase the LMNOP Canadian Equity Fund instead. This will maintain your exposure to Canadian equity, but the two assets are different for tax purposes, so you will have gained a tax loss.
The good news for fund owners: like it or not, most large cap equity mutual funds are essentially closet indexers (the secret is out). So, it really makes no significant difference if you sell one company fund and buy another. What does make a difference is the type of fund. Do not sell a growth fund and repurchase a value fund – the return characteristics likely will not be the same. So – do your research as far as the sector, but rest assured that broad market mutual fund managers are going to fall very close to the benchmark, making this a fairly reliable strategy for mutual fund investors.
Individual Stock Holders
For those who have specific stocks in your portfolio, the process is a little bit less ideal, but still viable. You essentially have two options:
- Replicate the strategy above, but instead of using funds that are similar, use stocks that are similar. For instance, imagine that you own shares in Coca-Cola. You could sell your shares in Coke and buy Pepsi instead. These two companies are going to have very similar returns over the next 30 days: much of the risk in both stock prices is based largely on a global lack of liquidity, not whether people prefer one type of cola beverage over another. So, you can get out of Coke, crystallize your loss, move over to Pepsi for 30 days, and then repurchase Coke after the period has elapsed.
- Or, you can replicate the strategy above, but instead of using funds that are similar, use an ETF or index fund to simulate the return of the asset class you have harvested losses from. For example, you may have a holding in Bank of Montreal. You could sell this holding, trigger your losses, and then purchase the iShares Financial Services ETF (XFN) to maintain exposure to the financial services sector. While this is not a perfect replication of the BMO holding, you would still participate in the upside that the sector may experience while you are out of BMO for the required period.
In both the examples above, there may be fees involved for trading that should be factored in to the cost/benefit analysis. Some brokerage houses have programs that will make a mass purchase of the losing assets in your account, and then resell them to you in 30 days – referred to as REPO programs. These arrangements can help reduce the costs of this transaction if there are many holdings affected.
In all the proposed methods, you will note that I am not recommending one stock over another – in an ideal world, this is an impartial transaction. We are simply trying to maintain the appropriate asset class exposure for the period following the transaction.
Best of all, this portfolio manoeuvre can create immediate value to your portfolio. In the examples above, a $100,000 holding with a $25,000 loss will yield a $5,800 tax benefit. On a holding that is now worth $75,000, that is an effective return of 7.73%, and can begin your portfolio as it works its way back to par. The strategy is not perfect – it does mean more capital gains to accumulate in the future, but it may provide you with the ability to reclaim some lost taxes, and re-invest that money into the market to help ready your portfolio for market upside that will come in the future.