by 2022 is the year most stock market investors want to leave behind. But there may be a silver lining to this year’s carnage for investors who leave their dogs before the end of the year.
It’s called a tax loss sale, and it offers the opportunity to use those stock market losses back to cover taxes previously paid on capital gains, or to eliminate capital gains taxation in the future.
HOW TAXED SALES WORK
With a tax loss sale, capital losses from stock investments can be applied to taxes paid on capital gains as early as three years ago or indefinitely into the future. Since half of the capital gains in a non-registered trading account are taxed, half of the capital losses can offset capital gains taxes against the dollar.
If you accrued $10,000 in capital gains during last year’s market rally and claimed $5,000 as income, for example, $10,000 in capital losses will get you a full refund.
If you have not paid tax on capital gains in this year or the previous two years, these capital losses can be used to reduce or eliminate capital gains tax at any time in the future.
SEPARATE THE DOGS FROM THE SLEEPING GIANTS
Any competent tax professional will advise you to never make investment decisions based solely on tax implications, and deciding to sell tax losses is no different.
Even good stocks fall in broad market declines, and the last thing you want to do is drop a stock that’s poised to rally. That is why it is important to prepare a strategy well in advance before the end of the year. A qualified counselor can help distinguish sleeping giants from dogs.
One thing to keep in mind: U.S. stocks have taken a much bigger hit than Canadian stocks this year, but the U.S. dollar has strengthened considerably against the Canadian dollar. Losses can be mitigated by selling US dollar-denominated stocks and converting cash into Canadian dollars.
BEWARE OF THE PINALLY LOSS RULE
As with any tax strategy, the Canada Revenue Agency (CRA) has strict rules regarding the sale of tax losses.
The most important one is called the shallow loss rule, which prohibits buying back the same stock within 30 days of the tax loss sale. The superficial loss rule applies to redemptions on any registered or non-registered account in the name of the account holder and even the account holder’s spouse. If you want to buy back the same stock, you must wait at least 31 days after the sale.
USING TFSA AND RRSP CAN GET MORE TAX SAVINGS
It is important to note that tax loss selling or capital gains taxation does not apply to investments in registered accounts, including a Registered Retirement Savings Plan (RRSP) or Tax Free Savings Account (TFSA).
However, the tax savings from tax loss sales can generate additional tax savings by transferring the income from a non-registered account to a registered account.
While half of capital gains are taxed in a non-registered account, capital gains tax in a TFSA is zero. RRSP capital gains are fully taxed when withdrawn in retirement, as are income and original contributions, but investors can deduct their share of taxable income.
RRSP contributions made before March 1 can be deducted from 2022 income or carried forward to future years when your tax burden is heavier. With both RRSPs and TFSAs, capital losses are tax-free because capital gains are never directly taxed.
There are specific rules set by the CRA regarding tax loss sales and paying registered accounts that must be followed, so consider talking to a tax professional.
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