This time of year, we routinely generate interim gain/loss reports for clients’ taxable accounts since it provides ample time to make portfolio changes before the end of the tax year. The exceptions would be those corporate accounts that have fiscal year-ends that are different. In the event that there are sizable, realized capital gains since the start of the year, the aim is to crystalize losses on those securities that are under water, with enough time to replace said securities before the end of the year. This “harvesting” of losses typically occurs just before the end of November, but there are factors which suggest the practice may or should take place earlier.

 

Before we get into weeds, let’s first review why tax-loss selling usually happens closer to the start of December.  The Canadian Revenue Agency has very defined rules surrounding the treatment of capital gains on property. If there is a realized gain by year-end, half of that will go to the taxable income bottom line and taxed at the individual’s or corporation’s rate. If there are losses on paper (unrealized), these can be triggered and used to partially or fully offset the realized gain to-date.  For the purpose of this commentary, I am going to stick with individuals since there are situations where a tax professional may advise that capital gains be taxed in the corporation, rather than offset by losses.

 

One of the stipulations is that property or a security that is sold at a loss for the purpose of reducing a realized gain, cannot be repurchased anywhere from 30 days before settlement of the transaction and 30 days post settlement. If it is, then the superficial loss rule kicks in and it is disallowed.  Note, this is as simple as just buying the security in the same taxable account that it was sold. The rule applies to purchasing the security in any other account tied to the individual. If the individual is married, then the security cannot be re-purchased in that person’s accounts.  It also applies to corporations where the individual until and/or spouse has a controlling stake, as well as trusts where the individual and/or spouse is a beneficiary. 

 

If someone wants to dispose of a security that they actually like, but which just happens to be in a loss position, they normally will want to trigger that loss towards the end of November so that it can be bought back into the portfolio before year-end. The latter is an important point since if there is a security that is not wanted or is not appropriate for the portfolio, one would argue that it shouldn’t be there in the first place.

 

 

Some tax professionals will argue that tax strategy should not occupy a higher priority than investment strategy which is another way of saying – don’t sell something just to trigger a loss as it might disturb the structure objectives of the portfolio. It is a fair point, and applies to not only to loss harvesting, but decisions about triggering gains as well (we all remember the outcome when people refused to sell their Nortel shares for fear of triggering large capital gains taxes). If the security in question is unique and its characteristics cannot be replicated with the use of another security, then the accountant view is correct. In reality though, most Canadian investors hold securities that have very close cousins or even siblings.  This is where investors have to be careful though. 

 

CRA has clear and muddied rules around so-called “identical” securities.  For example, you could sell one class of a company’s shares at a loss and buy another class, but if either was convertible into the other, then the superficial rule could apply. Index mutual funds and exchange traded funds (ETFs) also fall into this trap.  Because of their passive nature, there is no material difference between say a TSX60 fund at one shop at another, so CRA could disallow a loss on one if the other one was purchased. That said, you could sell a TSX60 fund and buy a Canadian large cap fund.  Similarly, you could sell a universe Canadian government bond fund and buy a narrower or actively managed fund. The chart below shows the correlation of the TSX and TSX60 over the past five years (source: Copyright@2022 Bloomberg Finance L.P.), where the range has been 98.3% to almost 100%.  In other words, a pretty good replacement.

 

 

Okay, with the broader rules and definitions understood, what is the strategy this season? First, it is unlikely that the majority of investment accounts out there have significant realized gains on the book. This is not a repeat of previous cycles where an overextended equity market prompted rebalancing trades that created large, realized gains. We did take equity off the table towards the end of last year, which did result in larger-than-average realized gains; but this year has been about making more nimble tactical adjustments and I would think the same has been true for other advisors. Let’s assume that there aren’t a lot of gains this year to offset. Some may then say, why bother with selling things today at a loss?

 

For one, CRA dictates that any losses triggered in the current tax year must be used against gains in the same year. If they exceed those gains, then you can carry the losses back up to three years.  What if you had no net realized gains in 2019, 2020 or 2021? In that case, CRA allows you to carry losses forward indefinitely. Unless you are an abject pessimist and think financial markets are in a state of perpetual decline, there is going to be a time when markets are rallying again and, more importantly, when your allocation to risk assets might be higher than desired and you will be selling (at a profit) to trim. Now, don’t faint, but the same might also apply to fixed income investments.  The other possibility is that you pass away or wrap up a corporation, with sizable capital gains at that point in time. The ability to carry forward losses to that point in time could be worth dollars in the bank, especially if one envisions an environment down the road where personal and corporate income tax rates are higher than where they are now.

 

 

In terms of the strategy today, I would compare it to what we did following the market rout at the beginning of the pandemic. Back then, after equities and some riskier fixed assets fell out of bed, our view was that fiscal and monetary policy responses would be swift. We didn’t know the rebound in risk assets would be as fast as what emerged in 2020, but even a moderate rebound would trim losses – losses that could be used to offset gains in the prior three years or down the road. At the time, the strategy was aimed at going after past gains since we had just come out of a fairly decent run since the financial crisis. Today, even with past gains less substantial, the situation offers up a similarly short window.

 

This is definitely true of fixed income holdings. Yes, this week’s CPI report suggested an even tougher monetary response into year-end, but we are much closer to the top in bond yields, which means losses might be reaching a local maximum. Triggering losses in this space might make sense and even if you were concerned about missing out on an impending rebound, there are various options on the table for replacing exposure in fixed income regardless of segment. To be honest, even moving to cash from fixed income for the sake of 30 days wouldn’t be the worst decision, again given the scenarios being painted for the last two central bank meetings in Canada and the US this year. Plus, most liquid money market options are paying rates that would be comparable to investment grade bonds last year.

 

The equity side of things is different.  Thursday’s response to a disappointing CPI report probably looked as irrational as other moves in recent weeks. Stock index futures fell out of bed in the minutes after the report, but soared by the afternoon. Some say this stemmed from algo trades that were triggered on the back of some of the major indices reaching their 50% retracement mark of post-pandemic gains. It’s possible that stocks might be able to continue this bounce, but as we have told clients, if data this month supported a continued aggressive approach by central banks, then the probability of a severe recession would rise into 2023. And history tells us that bad recessions make for large corrections in stocks, or second-wave corrections. If so, then there might be less of a chance of missing out on an equity rebound by triggering losses. That doesn’t mean we simply go to cash either. As mentioned, fixed income offers a relatively more attractive place to park loss-generating cash. And certain higher dividend paying segments of the equity market (like REITs, utilities, and quasi-utilities) might be a good place to move into.

 

We will definitely be working closely with clients and their accountants on these strategies and I would strongly suggest that you do the same before embarking on any tax harvesting this season.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.