You can’t win ‘em all when it comes to investing. Sometimes an investment doesn’t pan out and you end up in a loss position. When such investments are held in taxable investment accounts, they can be sold, which crystalizes the capital loss. Those capital losses can be used to offset taxable capital gains in the current year, with any excess carried back to the previous three years or carried forward indefinitely. This provides a silver lining where a poor-performing investment can lead to tax savings.
However, to reap the tax benefits associated with capital losses, it’s important to avoid the superficial loss rules. A superficial loss can’t be used to offset capital gains for tax purposes. Instead, the loss is added to the adjusted cost base (ACB) of the identical property.
Conditions for a superficial loss
For a capital loss to be deemed superficial, two conditions must be met:
- You or an affiliated person must buy the same or identical property during the 30 calendar days before or after the settlement date of the sale (61 days total).
- You or an affiliated person still owns the same or identical property 30 calendar days after the settlement date of the sale.
Affiliated persons can fall into one of four categories for the purposes of the Income Tax Act (Canada):
- individuals including yourself or your spouse¹
- corporations controlled by you or your spouse
- partnerships controlled by you or your spouse
- trusts where you or your spouse are a majority beneficiary, such as your registered retirement savings plan (RRSP), registered retirement income fund (RRIF), and tax-free savings account (TFSA). This also applies to a registered education savings plan (RESP) where you or your spouse is a subscriber.
Identical properties are the same in all material respects, so that a prospective buyer wouldn’t prefer one over another. To determine whether properties are identical, compare the inherent qualities or elements that give each property its identity.
Some examples of identical properties may seem obvious enough. For instance, take the common stock of two different companies in the same sector. They aren’t identical properties as they represent ownership in two different corporations.
What about different classes of stock in the same company? At first glance, these may seem like identical properties, and they could be. But if you owned shares from both the voting and non-voting classes, these wouldn’t be identical, as the right to vote is a material difference.
What if the voting shares were convertible into non-voting shares? Simply having the right or privilege to convert the voting shares into non-voting shares makes them identical properties under the definition of a superficial loss.
This isn’t as easy as it looks, is it?
Selling only a portion of an investment, as opposed to the entire position, may still lead to a superficial loss. When this occurs, part of the capital loss may be available to offset capital gains in the current tax year or previous three years, or carried forward indefinitely. The other portion of the loss would be superficial and added to the ACB of the remaining shares. The amount of the superficial loss is determined by a partial disposition formula:
SL = (least of S, P, or B)/S x L
SL is the superficial loss
S is the number of items disposed of at that time
P is the number of items acquired in the 61-day period
B is the number of items left at the end of the period
L is the loss on the disposition as otherwise determined
Let’s assume you buy 120 shares of XYZ at a total cost of $480 ($4/share) on January 2. On March 15, you sell 80 shares for a total of $240 ($3/share). Two days later, you purchase an additional 50 shares for $165 ($3.30/share). The remaining shares are held for at least 30 more days and no other transactions on identical property occur in the 61-day superficial loss period.
The sale on March 15 would result in a partial superficial loss. Based on the partial disposition formula, the superficial loss would equal (the least of S (80), P (50), or B (90)) / S (80) x L ($80) = $50. As a result, the $50 superficial loss would be added to the ACB of the reacquired shares, increasing it to $215 ($50 + $165). The remaining $30 capital loss can be used to offset taxable capital gains in the current year with the excess either carried back three years or forward indefinitely.
There are a few ways to successfully realize capital losses and avoid the superficial loss rules. All strategies below assume the sale of an investment.
- Assuming it’s not a partial disposition, wait at least 31 days from the settlement date before repurchasing the same investment or an identical property.
- Don’t repurchase an identical property sold in your non-registered account within your registered account (RRSP, RRIF, TFSA, etc.), or vice versa, within the superficial loss period. In-kind contributions to registered accounts of non-registered investments with unrealized losses will also result in such losses being denied.²
- Don’t purchase an index fund where the underlying index tracked is the same (e.g., S&P/TSX Composite Index) as the investment sold within the superficial loss period. This applies even if the investments come from two different fund companies.
- Don’t repurchase the exact same mutual fund with a different fee structure (e.g., Series A vs Series F) within the superficial loss period. The difference in fees alone doesn’t change the fact the funds are identical in all other respects.
- If you’re selling a mutual fund trust, consider purchasing the same fund structured as a mutual fund corporation (or vice versa). These wouldn’t be considered identical properties because the legal structure of each (trust vs corporation) is different, providing different rights to each investor.
- If selling a mutual fund or exchange-traded fund (ETF), consider repurchasing another that invests in the same asset class (e.g., Canadian equity) but has a different investment mandate (e.g., growth vs dividend income). Doing so can maintain exposure to a desired asset class or sector without waiting for the superficial loss period to elapse.
- Consider selling a mutual fund where the currency (e.g., Canadian dollars) is hedged and repurchasing the mutual fund where the currency is unhedged (or vice versa). The effect of the currency hedging strategy, or lack thereof, may alter the performance profile of the investments, even if the mutual funds have the same underlying assets.
- Consider gifting investments with unrealized losses to an adult child, parent, or sibling. These losses wouldn’t be deemed superficial because the recipients aren’t affiliated persons.
- Superficial losses aren’t all bad. In fact, when it comes to spouses, they can be a very good thing under the right circumstances. To learn more about how spouses can make superficial losses work for them, see Capitalizing on capital losses.
As with most rules, there are exceptions. For superficial losses, exceptions include these situations:
- If you become a non-resident of Canada, this can result in the deemed disposition of assets.
- The property is deemed sold as the result of a change of use.
- There’s a deemed disposition because of the death of the investment’s owner.
- You sell the investment but become income tax exempt within 30 calendar days of the disposition.
Beware of automatic purchases
Some automated purchases may occur during the superficial loss period that could result in part or all of a capital loss from a sale being a superficial loss. Such transactions can include a pre-authorized contribution (PAC) and reinvested distributions for mutual fund investors. For stock investors, examples can include dividend reinvestment plans (DRIPs) or employee share purchase plans. In such situations, to avoid the application of the superficial loss rules, you may consider temporarily cancelling a PAC or timing a sale to avoid the automatic reinvestment of distributions or dividends.
Should you protect yourself from superficial losses?
The discussion of superficial losses reaches its peak near the close of each calendar year as investors sell investments with losses in the hopes of using them to reduce capital gains realized earlier in the year. Remember that investment objectives and long-term goals trump short-term tax considerations, and not the other way around. Superficial losses can happen year round, and knowing the rules can help make sure that crystallized losses can be used for their intended purpose: tax savings.
1 The term spouse includes a common-law partner as defined by the Income Tax Act (Canada). 2 In-kind contributions to an RESP are an exception to this rule, and capital losses on such transfers are not automatically denied. However, they’ll be considered a superficial loss if still owned 30 days after transfer.
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