What is Tax Loss Harvesting?

When you sell an investment, whether it’s a stock or an ETF, below the original purchase price, you trigger a capital loss. In Canada, you can apply capital losses against capital gains, helping you lower or nullify completely taxes owed on investment earnings. If you do this strategically, meaning you deliberately sell a losing investment for the capital loss, it’s called tax loss harvesting.

The good thing about capital losses – once you incur a loss, you can carry it forward indefinitely, or apply it against capital gains from the previous three tax years. For example, if you had a capital loss of $5,000 this year, along with a $4,000 capital gain two years before, you could apply the $5,000 against the $4,000 gain on your tax filing. After you cover the $4,000, you’d still have $1,000 left for any capital gains you incur in the future.

Benefits of tax loss harvesting

Tax loss harvesting can be a valuable strategy for Canadian investors looking to reduce their taxable investment income and improve long-term after-tax returns. By selling losing investments, you can strategically manage your capital gains while rebalancing your portfolio. Key benefits include:

Lower Capital Gains Taxes: Realized capital losses can offset capital gains, reducing or even eliminating taxes owed in that tax year.
Carry-Forward Tax Advantages: Unused capital losses can be carried forward indefinitely to offset future gains or carried back up to three years to recover taxes paid on past gains.
Portfolio Rebalancing Opportunity: Selling underperforming investments allows you to reallocate into stronger or more diversified assets without incurring additional taxable gains.
Improved After-Tax Returns: Reducing tax liability keeps more of your investment returns compounding over time.

Drawbacks of tax loss harvesting

While tax loss harvesting can be beneficial, it’s not without its downsides. Canadian investors should carefully consider the following:

Superficial Loss Rule: The CRA disallows a capital loss if you repurchase the same or an identical security within 30 days before or after selling it. This rule can limit your ability to quickly re-enter a position.
Possible Missed Gains: Selling a stock that later rebounds strongly may mean missing out on potential future profits.
Transaction Costs: Frequent buying and selling can increase trading fees, which may erode the tax savings, especially on smaller portfolios.
Short-Term Focus: Overemphasis on tax strategies may lead to decisions based on short-term tax benefits rather than long-term investment goals.

Tax loss harvesting example

Here’s a simple example of how tax loss harvesting works in practice:

Initial Investment
- Peter buys 100 shares of utility stock ABC at $10 per share → $1,000 total investment.
Stock Drops in Value
- Stock ABC falls to $6 per share → now worth $600 (a $400 loss).
- Believing ABC will continue to perform poorly, Peter sells the shares, locking in the $400 capital loss.
Reinvesting in the Same Sector
- Peter still believes the utilities sector will do well, so he uses the $600 to buy a utilities-focused ETF.
- The ETF performs well, and by year-end, Peter gains $400 on this investment.
Tax Impact
- Normally, Peter would owe capital gains tax on the $400 gain.
- However, his $400 capital loss offsets the $400 gain, meaning no capital gains tax for this investment.

What’s the superficial loss rule?

Tax loss harvesting can be a great strategy to lower your tax bill. But it comes with one big restriction: you have to wait 30 days to repurchase an investment you sold for a loss, if you want to claim the capital loss on your taxes.

So, again, let’s say you sell stock ABC for a capital loss of $400. The moment after you sell your stock, you realize that company ABC is not as bad as you thought. In fact, it’s headed for good times. You buy back your stock, and you end up earning $400 on your ABC stocks.

Now, if you sold those stocks for that $400 gain, you can’t then use your previous $400 loss to offset the gain. That wouldn’t be right. In this case, you would pay taxes on the $400 gain, and the previous capital loss would basically be null.

Additionally, the CRA won’t credit you the tax loss if someone “affiliated” with you buys shares in ABC. So, for instance, if you sell your ABC stock, but advise your spouse to buy shares on your behalf, the CRA won’t let you use your $400 loss against any gains.

How can you work around the superficial loss rule?

The superficial loss rule (called the ‘wash sale’ rule in the US) says you can’t buy the same security within 30 days after selling it for a loss. But that doesn’t mean you can’t buy any security.

Savvy Canadians often sidestep the superficial loss rule by buying shares in an ETF or buying a different stock that’s closely related to the stock that you sold. For instance, if you had a losing tech stock, you could still buy shares in a tech-focused ETF or in a winning tech stock. This allows you to continue exposing your money to the market, while also getting rid of stocks that aren’t right for your portfolio.

Can you use tax loss harvesting inside registered retirement accounts?

No. Tax loss harvesting doesn’t work if you incur a capital loss inside an RRSP or TFSA.

The reason is simple – these retirement accounts already have tax advantages built into them. When you sell investments above the purchase price inside a RRSP or TFSA, you won’t pay taxes on the gain. For that reason, the CRA doesn’t let you use capital losses inside retirement accounts to offset gains in other accounts, no matter how big the loss.

What should you know about end-of-year deadlines?

Keep in mind that you must settle your losses within a calendar year if you want to offset gains realized in that same year. For instance, if you incurred a capital gain of $400 in February, and you’re losing $400 in ABC stock in December of the same year, you’ll want to sell your shares of ABC before December ends, if you want to offset gains and losses for that year, that is.

Now, of course, capital losses can be applied to gains incurred in the previous three years. So you could technically sell your ABC stock in January of the following year and still get a capital loss. You would just have to wait another year before you could apply that $400 loss against the $400 gain.

Foolish bottom line on tax loss harvesting

Suffering losses on your stocks is never fun, but tax loss harvesting can help you turn a losing stock into a tax advantage. As long as you play by the rules—that is, you don’t buy back a losing stock within 30 days after selling it for a loss—you can apply your losses against your gains.

And, if you don’t have any gains for a specific year, you can store your losses in your arsenal: capital losses can be carried forward indefinitely, meaning you could wait until you have significant gains, then use your capital losses to lower your tax bill.

For those new to investing, you might want to consult a tax professional if you plan to use tax loss harvesting. Since your situation might be unique, a tax professional can help you understand if this strategy is the right move for you.

FAQs on tax loss harvesting

Does tax-loss harvesting really make a difference?

Yes, tax-loss harvesting can significantly reduce your taxable capital gains, lowering the amount you owe to the CRA in a given year. Over time, reinvesting those tax savings can also improve your portfolio’s after-tax returns.

What is the $3,000 capital loss rule?

The $3,000 capital loss rule is a U.S. tax provision and does not apply in Canada. In Canada, capital losses can only offset capital gains, but unused losses can be carried forward indefinitely or carried back up to three years.

What is Tax Loss Harvesting?