Planning for Net Capital Losses
Market downturns can provide planning opportunities to take advantage of losses and offset other capital gains. There are some of the pitfalls to avoid and offers tax strategies you can use to decrease your losses. After all, financial planning is essential when the markets go up and down.
A capital loss must first be applied against any capital gains (including capital gains distributions) of the current year. However, once these capital gains have been used, the balance of the loss may either be carried back to offset capital gains in any of the three prior years or carried forward indefinitely to offset capital gains of future years.
If you have realized significant capital losses this year, there is a temptation to realize gains later in the year to offset some of these losses immediately. However, if you have net capital gains in any of the three previous years, you can also consider applying the net capital losses realized this year against the net capital gains realized in any one or more of those years. In this way, you can receive a partial or full refund of the capital gains taxes you previously paid.
If you have net gains in more than one of those years, there is no requirement that you must apply the loss against the earliest year first. For example, if you realized a net capital loss in 2023, and net capital gains in 2022 and 2020, you may choose to offset your losses this year against the gains in 2022 first, as opposed to 2020. You may want to do this if your personal tax rate was higher in 2022 than in 2020 and maximize the amount of refund you receive or reduce the amount you owe.
Alternate Strategies
There are a number of strategies you may consider if you have accrued losses in investment portfolios. With proper planning you can realize and use them on a tax-effective basis. The following strategies generally assume that the investment will continue to be held in some form even though the accrued loss will be realized and used.
Beware the Superficial Loss Rule
Canada’s tax rules require you to wait at least 30 days before repurchasing the same property if you want to be able to claim the full amount of the capital loss. This is known as the superficial loss rule. In addition, if you or your spouse/common-law partner purchase property identical to that sold within the period that begins 30 days before and ends 30 days after the disposition, and still hold it on the 31st day after the disposition, then the loss on the original sale will be superficial
A superficial loss is deemed nil, and will be denied and cannot be claimed. The denied loss is added to the adjusted cost base of the acquired property.
The superficial loss rule also applies if the property is acquired by a company controlled by you and/or your spouse/common-law partner during the period outlined above. Finally, the superficial loss rule also applies to trusts on which you or your spouse/common-law partner is a majority interest beneficiary. As a result, the strategy of selling property held in a non-registered account and reacquiring the property inside a Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), Registered Education Savings Plan (RESP) or Tax-Free Savings Account (TFSA) is not viable.
In-Kind Transfers to Registered Plans
Often you may consider funding your registered plan via an in-kind transfer of securities from your non-registered account. In-kind transfers from your non-registered account to your registered plan (e.g., RRSP or TFSA) will result in a disposition for tax purposes. Any capital gains triggered as a result of the disposition is taxable. A capital loss triggered from the in-kind transfer will be denied and unusable under Canada’s “deemed to be nil” rules. It is therefore more advantageous to realize the capital loss on the security within the non-registered environment first, and then transfer the proceeds into the registered plan.
Transfer the Mutual Fund Units to a Child or Parent
The superficial loss rule does not apply in the case of an immediate acquisition of the same units by a child or a parent. Therefore, it may be possible to realize a loss by transferring the mutual fund units to a child or parent.
Transfer from Trust to Corporate Version of Same Mutual Fund
Mutual funds and exchange traded funds (ETFs) can be set up legally as trusts or corporations. Many corporate funds have different classes of shares. Each class represents a different portfolio of securities, with a different investment mandate (e.g., technology, Europe, etc.). If you have an accrued loss on the trust version of a particular mutual fund, you could switch to the corporate version of that fund and crystallize the loss. A switch either way between the trust and the corporate class is considered to be a disposition.
When the other version of the fund is purchased, there is no superficial loss. This is because you are buying back a different legal structure, and not an identical property. Note, however, a transfer between different classes of shares within the same mutual fund corporation will likely be caught under the superficial loss rules. The reason is that shares of the same mutual fund corporation are considered identical property to each other.
Purchase Another Mutual Fund Trust in the Same Category
As an alternative to switching from a mutual fund trust to a mutual fund corporation, it may also be possible to realize a loss by switching from one mutual fund trust to another mutual fund trust in the same category. For example, it may be possible to realize the loss incurred from one Canadian equity fund trust by switching to another Canadian equity fund trust within the same family. The ability to claim the loss in this case will hinge on whether the two Canadian equity fund trusts are considered to be “identical.”
“Identical” Property
The Canada Revenue Agency (CRA) has stated that the determination of “identical” investments is a question of fact. Several factors are taken into consideration, including the legal structure of the investment entity, the composition of assets, risk factors, investor rights and any applicable restrictions. Properties are generally considered identical where they are the same in all material respects and an individual would not have a preference for one over
Common examples of identical property include the same class of capital stock of a corporation or units of a mutual fund. The determination of whether properties are considered identical would require a comparison of the inherent qualities or elements of each property and, therefore, professional advice should be sought in this regard.
Procedure to Carry Back a Loss
The procedure to carry back a loss from the current year to any of the three preceding years is quite simple – you just need to complete CRA Form T1A “Request for Loss Carryback.” It is available on the CRA website and included in most tax preparation software packages. On this form you select the years) in which you wish to apply the capital loss. The CRA will reassess your return for that year and mail you a refund cheque.
Conclusion
While the topic of losses is not something that most individuals wish to discuss, considering one or two of the above strategies may go a long way toward mitigating some of the pain associated with these losses. Nevertheless, every family and individual is unique, so it is important that you talk with your advisor, lawyer and/or tax advisor to find out the best available options in your situation. Once you have your plan in place, don’t forget to review it from time to time, or as your circumstances change.
