Tax-loss selling season is quickly approaching and it's time to review your portfolio to sift out non-performing assets. Selling them can generate capital losses to help minimize your tax obligations.

So take a hard look at your holdings to determine what, if any, losses you want to crystallize so you can trim your holdings and raise cash that can be used to contribute to tax-deferred accounts or to buy bargain stocks, while realizing some useful capital losses.

Those losses can help offset capital gains this year or for the previous three years or they can be carried forward indefinitely to be used against future capital gains.

Seek Professional Advice

Using losses to reduce taxable income is a complicated and sophisticated tax strategy, so you want to talk to a professional to be sure it will work for you and fits your long-range financial planning. Go over your most recent Notice of Assessment carefully. You may already have enough capital loss carry forwards to offset capital gains if you took losses last year.

Be careful to avoid triggering the superficial loss rule that goes into effect when you, your spouse or common-law partner, or related corporation sell and reacquire the same holding within 30 days. Those rules will prevent you from claiming the loss.

As a long-term investor, it can be difficult to decide to let go of underperforming stocks that have sound fundamentals because you expect them to bounce back eventually. But think of it in this way:

Suppose you own a property that is not your primary residence or you own some other asset that has appreciated in value over the past few years. You have an offer to sell at a hefty profit and the gain would generate a large tax bill. You may be able to sell some of the under-performing holdings in your portfolio for a loss and use that to offset some, if not all, of the capital gain on the asset sale.

Even if you don't have a property to dispose of, you can still benefit from tax-loss selling. The strategy works with capital gains or losses from any non-registered investment, including stocks, bonds, mutual funds, exchange traded funds and real estate.

When You Cannot Use the Strategy

But the tactic cannot be used for investments in tax-deferred portfolios such as Registered Retirement Savings Plans (RRSP) and Registered Retirement Income Funds (RRIF). Also, losses triggered on the transfer of securities to a registered plan or a Tax-Free Savings Account (TFSA) cannot be used against capital gains. Moreover, the Finance Department imposes a 100 per cent tax on gains from swap transactions involving TFSAs (see below).

Consider instead selling investments outside your registered plan or TFSA, taking the losses and using the cash to contribute to the tax-deferred accounts. Your retirement or savings plan can buy back the investment as long as you wait the required 30 days to avoid triggering the superficial loss rule. If you don't wait, Canada Revenue Agency (CRA) won't allow the capital loss claim.

There are, however, ways to overcome this barrier. For example, if your tax-loss sale involves a bank stock and you think the banking sector has investment potential, you could buy a mutual fund or exchange-traded fund that is heavy in financial institutions to keep the same investment characteristics in your portfolio. Alternatively, you could buy shares in another bank. The same applies to mutual funds where there may be different classes of the same fund. Just shift the money to another class.

The January Effect

Another thing to keep in mind is that if you are planning to buy back investments, the earlier you finish your tax-loss selling the better your chances of purchasing them at a lower price once the 30-day waiting period ends, provided the tax-loss selling season is still in full swing. The annual sell-off tends to depress stock prices so if you play it right you can find bargains before the "January Effect" kicks in and share prices start recovering from the tax-loss sales.

The January Effect is a term used to describe a rally in stock prices during January that is generally attributed to the drop in price that typically happens in December as a result of the sell-off investors create to generate tax losses. The January Effect generally affects small cap stocks more than large caps.

To maximize your losses, consider deferring any further sales of securities with gains until January. This can also defer tax where there are no accumulated losses.
Alternatively, you could consider triggering gains in your portfolio that could be offset by unused capital losses you are carrying forward from previous years.

To carry back a loss to a previous year, you must file a Form T1A Request for Loss Carryback with the CRA. The agency will reassess returns you filed for the years you select and refund taxes paid on the earlier capital gains. Before you can carry back a capital loss, however, you must apply it to any capital gains you have, including gains from year-end mutual fund distributions.

The more capital gains tax you paid in the past three years, the more you might consider the tax advantages of tax-loss selling. But always seek professional advice and keep in mind that capital losses generally can only be used to trim or eliminate capital gains. They cannot be used to reduce other income except in the year of a taxpayer's death.

Penalties for Using TFSAs As Trading Accounts

Investors who use Tax-Free Savings Accounts (TFSAs) to trade investments face a 100 per cent penalty tax on income from:

  1. Deliberate over-contributions. This is aimed at thwarting investors who have tried to generate short-term gains in their TFSAs that far outweighed the current penalty of one per cent a month.
  2. Ineligible investments such as shares of a corporation of which the TFSA holder owns 10 per cent or more, or investments in entities that are not dealt with at arm's length. Land and general partnership units, even if held at arm's length, are also ineligible.
  3. Money from swap transactions in which shares or other property are transferred to a TFSA from a registered or non-registered retirement account in exchange for cash or other property. This is aimed at preventing investors from shifting assets to the tax-deferred savings account at prices below current market values.