It’s been a year mostly to forget for equity investors. While markets have rallied somewhat during the past month, they have been solidly in the red for much of 2022. This means a lot of stocks have been sold, but in addition, many portfolios are showing big losses on paper as investors continue to hold depressed issues in the hope prices will recover in the near term.

While patience is normally the watchword during bear markets – history shows the market always eventually recovers – there can be an exception to that rule. Investors should take the opportunity, in light of market events, to undertake a tax-efficiency review of their portfolio to determine whether any realized capital gains can be offset by either monetizing any unrealized losses in the current year or utilizing loss carry forward or the carry-back mechanism.

The concept is fairly simple: you are allowed to deduct the amount of losses resulting from the sale or donation of a stock or other capital property from the amount of any gains realized from the sale of another capital investment. While equity gains have been hard to come by this year, you also can use a loss realized this year to offset any realized gains during any of the three preceding taxation years (i.e., 2019, 2020, or 2021).

“Doing so can allow you to recoup some of the tax you paid on those gains’” says Joseph Micallef, National Tax Leader, Financial Services with KPMG in Canada. You also can retain the loss to reduce capital gains realized in any future taxation year.”

Identify Assets to Sell

If you have capital gains available to offset with a capital loss, and you currently are holding a money-losing stock that represents market exposure you no longer wish to have, the simplest solution is to sell it and replace it with something else more appropriate to your strategy and risk tolerance. You’d probably consider doing these regardless of market conditions.

But if selling a depressed holding would be contrary to your asset-allocation strategy or disrupt a long-term investment plan, then you can sell it and replace it with another position that provides similar market exposure that is in line with your overall investment. This is known as tax-loss harvesting.

However, investors cannot sell a security and thereby realize a loss, and then immediately buy it back to restore that identical position. “It’s important to be aware of the superficial loss provisions of the Income Tax Act, whereby capital losses realized can be deferred to the extent an identical position is required 30 days before or after the disposition giving rise to the capital loss,” Micallef says.

“When you add the amount of the superficial loss to the adjusted cost base of the substituted property, the amount of your capital gain will be decreased — or the capital loss increased — when you eventually sell the substituted property,” he says. “Corporate taxpayers also need to be mindful of the stop-loss rules, which similarly guard against a transaction being sold only to tax advantage, without any intention of actually disposing of it.”

How to do Tax Loss Harvesting

The following is a rundown on how capital losses can be used to reduce capital-gains tax, and how investors can monetize tax losses.

If you realize capital losses during 2022, you must first apply this amount against any capital gains realized during 2022 to produce a lower net-capital-gain total, of which one-half is taxable. If your losses exceed your gains for that year, you can use the remaining portion to reduce gains realized during any of the past three years. Any unused capital losses can be carried forward indefinitely. The amount of your allowable capital losses remaining from previous years is stated on your 2021 Notice of Assessment.

Consider the following example. Last February you purchased 100 shares of a financial-services company XYZ Inc. for $50 a share, or $5,000 total. Those shares are now trading at $30. You could sell them for $3,000 and realize a capital loss of $2,000, which you could use to reduce the total amount of capital gains you might be reporting for this year. Or you could apply it against any gains realized during the previous three years. To remain invested in financials, you could buy shares of a similar institution or units of a mutual fund that invests across this sector.

“For instance, if you reported $7,000 in capital gains in 2020, you could use your remaining unused capital losses realized in 2022 against taxable gain realized in either 2021, 2020, or 2019,” Micallef says.

To apply a capital loss against a previous year’s income, acquire CRA Form T1A, Request for Loss Carryback and complete “Part 5, Net Capital Loss for Carryback.” (For Quebec tax purposes, use Revenu Québec Form TP-1012.A-V.)

Carry-forward of Previous Losses

If you have losses realized in any previous year those may be used in any subsequent year to reduce any 2022 net capital gains realized. You claim this amount on the appropriate line on your tax return (no special form required). You must take note of the capital-gains inclusion rate that was in force for the year in which the loss was reported.

“When using allowable capital losses from a past year to reduce your 2022 capital gains, you will have to base those amounts on the “inclusion rate” that was in effect when the loss was realized,” Micallef says.

Since 2001, the inclusion rate has been one-half (50%). However, the rate was higher between 1988 and 2000, as follows:

• 1988 and 1989: two-thirds (66.66%)
• 1990-1999: three-quarters (75%)
• 2000: a specific rate stated on your 2000 Notice of Assessment
• Prior to 1988, the 50% inclusion rate also was 50%.

For example, say you sold share for a gain of $5,000 earlier this year, for a taxable gain of $2,500, based on the current 50% inclusion rate. If you have a $1,000 capital loss that has not previously been used to offset gains in other years, this amount can be used to offset this year’s gain. In a case where this loss was incurred in 1999 when the inclusion rate was 75%, you must calculate an adjustment factor, which is the midpoint of the two rates, or 66.66%. Thus, the net capital loss you could carry forward is $666.66.

Don’t Abandon Your Investment Strategy

While minimizing the overall taxes paid is a desirable goal, the old proverb of “don’t let the tail wag the dog” must be stated as tax decisions should not drive your overall investment strategy.

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