You can’t win ’em all when it comes to investing. Sometimes an investment doesn’t pan out, and you end up in a loss position. When such investments are held in taxable investment accounts, they can be sold, which crystalizes the capital loss. Such capital losses can be used to offset taxable capital gains in the current year, with any excess carried back to the previous three years or carried forward indefinitely. This provides a silver lining, where a poor-performing investment can lead to tax savings.
However, to reap the tax benefits associated with capital losses, it is important to avoid the superficial loss rules. A superficial loss cannot be used to offset capital gains for tax purposes. Instead, the loss is added to the adjusted cost base (ACB) of the identical property.
Conditions for a superficial loss
For a capital loss to be deemed superficial, two conditions must be met:
For the purposes of the Income Tax Act, affiliated persons fall into one of four categories:
- 1. Individuals, namely yourself or your spouse1
- 2. Corporations controlled by you or your spouse
- 3. Partnerships controlled by you or your spouse
- 4. Trusts where you or your spouse are a majority beneficiary, such as your Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF) and Tax-Free Savings Account (TFSA). This also applies to a Registered Education Saving Plan (RESP) where you or your spouse is a subscriber.
“Identical properties” are the same in all material respects, so that a prospective buyer would not prefer one over another. To determine whether properties are identical, it is necessary to compare the inherent qualities or elements which give each property its identity.
For example, you sell 100 units of XYZ mutual fund (or shares of a company, or units of a segregated fund) for a capital loss of $200. The next day you buy back 100 units of XYZ mutual fund at a cost of $1,000. If you still own the units 30 days after the sale, your $200 capital loss will be denied and added to the ACB of the re-acquired units, increasing it to $1,200 ($1,000 + $200).
Selling only a portion of an investment, as opposed to the entire position, may still lead to a superficial loss. When this occurs, part of the capital loss may be available to offset capital gains in the current tax year, previous three years or carried forward indefinitely. The other portion of the loss would be deemed superficial and added to the ACB of the remaining units.
There are a few ways to successfully realize capital losses and avoid the superficial loss rules. All strategies below assume the sale of an investment.
- 1. Assuming it’s not a partial disposition, wait at least 31 days from that settlement date before repurchasing the same investment or an identical property.
- 2. Avoid repurchasing an identical property sold in your non-registered account within your registered (RRSP, RRIF, TFSA, etc.) account and vice versa within the superficial loss period. In-kind contributions to registered accounts of non-registered investments with unrealized losses will also result in such losses being denied.2
- 3. Avoid purchasing an index fund where the underlying index tracked is the same (e.g., S&P/TSX Composite Index) as the investment sold within the superficial loss period. This applies even if the investments come from two different fund companies.
- 4. Avoid repurchasing a different series (e.g., Series A vs. Series F) of the exact same mutual fund within the superficial loss period.
- 5. If selling a mutual fund trust, consider purchasing the same fund structured as a mutual fund corporation (or vice versa). These would not be considered identical properties because the legal structure of each (trust vs. corporation) is different, providing different rights to each investor.
- 6. If selling a mutual fund or ETF, consider repurchasing another that invests in the same asset class (e.g., Canadian equity) but has a different investment mandate (e.g., growth vs. dividend income). Doing so can maintain exposure to a desired asset class or sector without waiting for the superficial loss period to elapse.
- 7. Consider gifting investments with unrealized losses to an adult child, parent or sibling. These losses would not be deemed superficial because the recipients are not affiliated persons.
- 8. Superficial losses aren’t all bad. In fact, if you can’t make use of capital losses, you can use the superficial loss rules to transfer them to your spouse. To learn more about this, see Tax Managed Strategy # 1 Capitalizing on Capital Losses (MK1381).
Investors tend to focus on superficial losses near the close of each calendar year as they sell investments with losses in the hope of using them to reduce capital gains realized earlier in the year. Remember that investment objectives and long-term goals trump short-term tax considerations and not the other way around. Superficial losses can happen year-round, and knowing the rules can ensure that crystallized losses can be used for their intended purpose: tax savings.
If you have clients who could benefit from this information, send them a copy of our easy-to-read piece (MK358854), which is available on the Advisor Portal.