Capitalizing on capital losses

If you or your spouse¹ have realized capital gains in the last three years, consider selling an investment that has dropped in value to recover the taxes paid on those gains.

Stock market volatility may cause investors to worry about their investments. Many may feel that they need to take action and reorganize their portfolios, even if they’re in a loss position. Once the decision is made to crystallize losses, our capitalizing on capital losses strategy can be used to maximize the tax benefit on portfolio losses. This strategy is based on carrying back any losses that exceed current year capital gains to a previous year with net capital gains.

The Income Tax Act (Canada) requires capital losses to first be applied against capital gains realized in the current year. If there’s any remaining balance, the net capital losses can be used to either reduce taxable capital gains in any of the three preceding years or in any future year.

The best strategy is to carry the losses back to the earliest year in which you have capital gains before it falls out of the three-year window, especially if your marginal tax rate in that year is at least equal to the other 2 years. For example, the earliest date you’re allowed to carry back 2025 losses is 2022. To learn more about realizing capital losses to reduce capital gains, see How to use tax-loss selling to turn capital losses into tax savings.

If you don’t have capital gains this year or the previous three years but your spouse does, it’s possible to transfer capital losses to your spouse.

First, the investment is sold to crystallize the capital loss. Immediately afterwards, your spouse buys the exact same amount of the identical investment. Your spouse then sells the investment after waiting at least 30 days after the transaction’s settlement date. The capital loss realized on your sale will be denied under the superficial loss rules and added to your spouse’s adjusted cost base (ACB) instead, thereby transferring the capital loss.

A closer look at the tax savings

John has a net capital loss of $20,000 realized this year that he can either carry back to a previous year or transfer to his spouse. He and his spouse are in a 46% marginal tax bracket in the current year and previous 3 years.

Here’s how the tax savings stack up.

Type of income (capital loss at a 50% inclusion rate)
Loss amount      $20,000
Tax savings at a 46% marginal tax rate (actual tax rate may vary)(loss amount x inclusion rate x marginal tax rate) = $20,000 x 0.5 x 0.46 = $4,600

Carrying back John’s loss to a previous year or transferring it to his spouse results in a recovery of $4,600 in taxes previously paid.

Note

If you or your spouse repurchase property identical to one that was sold within the period that begins 30 days before and ends 30 days after the disposition (settlement date), and still hold it on the 30^th day after the disposition, then the capital loss on the original sale will be denied under the superficial loss rules. The denied loss is added to the ACB of the acquired property.

Tip

A trust version of a mutual fund isn’t identical to the corporate class version of the same mutual fund. Therefore, capital losses realized by the sale of a mutual fund trust won’t be denied under the superficial loss rules if the same fund is purchased in a mutual fund corporation because you’re purchasing a different legal structure.

The same strategy can be used to transfer capital losses on your personal taxable investments to your corporation—that is, you sell an investment and realize the capital loss. Immediately afterwards, your corporation buys the exact same amount of the identical investment. Then your corporation sells the investment after waiting at least 30 days after the transaction’s settlement date. The capital loss realized on your sale will be denied under the superficial loss rules and added to your corporation’s ACB instead. This could be beneficial if your corporation has realized capital gains on its passive investment portfolio and may be subject to a reduction of its small business deduction (SBD). The capital loss realized by the corporation will reduce its realized capital gains in the same year and help preserve its SBD.

Unfortunately, in a corporate setting, this strategy is a one-way street. It won’t work if your corporation tries to transfer capital losses to you or an affiliated person (e.g., your spouse). In this case, the capital loss upon the sale of the investment will remain in the corporation and won’t be added to your ACB when you purchase it. Further, the corporation won’t be able to use the capital loss for tax purposes until you or an affiliated person of the corporation sell that same investment. Also, neither you, nor an affiliated person could’ve acquired the substituted property in the 30 calendar days before and after the sale by the corporation and still hold the substituted property on the 30^th day after the transaction’s settlement date.

Investors who:

• are selling their investments at a loss and who have little or no capital gains in the current year
• had capital gains, or their spouse had capital gains, in the past three years

To apply for a loss carryback, investors need to:

• complete form T1A Request for Loss Carryback
• attach the completed form T1A to this year’s income tax return.

Canada Revenue Agency (CRA) will then automatically apply the losses to the previous years requested on the form.

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1 Includes a spouse or common-law partner as defined by the Income Tax Act (Canada).