Tax-loss selling (or tax-loss harvesting) is a strategy for lowering your Canadian capital gains tax that involves selling a security at a loss in order to offset your capital gains. You can then deduct these losses against your taxable capital gains in the current tax year.

For example, December 24 is the 2010 deadline for tax-loss selling on the Toronto Stock Exchange. If you sell at a loss on or before that date, you get to deduct your loss against your 2010 capital gains.

If you still have capital losses left over, you can carry them back up to three years (2009, 2008 and 2007), or forward indefinitely to offset past or future capital gains.

Overlooking the “superficial loss rule” will cause your capital loss to be disallowed

If you are considering using tax-loss selling to minimize capital gains, you should be aware of the “superficial loss rule.” The rule states that if you, your spouse or a company you control buys the same security within 30 days before or after the sale, you are not permitted to claim the capital loss for tax purposes.

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However, there are some ways to maintain stock-market exposure during the 30-day period following the sale. For example, if you decide to sell oil and gas shares that you bought at their 2008 highs in order to realize a capital loss, but then decide oil and gas stocks are poised to rise further, you can buy a mutual fund that is heavily weighted in oil and gas firms to keep yourself exposed to that sector.

Or you could buy shares in a company that is in a similar business as the one you sold. For instance, say you bought Suncor Energy (symbol SU on Toronto) for $60 in 2008 and sold it for $35 in 2010, then bought shares of Cenovus Energy (symbol CVE on Toronto) within 30 days of selling Suncor. You wouldn’t trigger the superficial loss rule, even though the companies have a great deal of similarity in the businesses they are in. (We cover both Suncor and Cenovus in our Successful Investor newsletter.)

Look beyond Canadian capital gains tax when deciding when to sell

It’s always a good time to sell bad stocks, or stocks that are wrong for your portfolio. But you need to balance that rule against the fact that in the final couple of months of the year, some investors dump stocks without thinking, just to cut their taxes. In some cases, they simply want to sell and be done with it. In others, they intend to buy back the stock after 30 days (but as we mentioned, if you buy back any sooner, you cannot deduct your loss.)

As a result, stocks that have been weak tend to stay weak in the final month or two of the year. But the best of the bunch can put on extraordinary recoveries when tax-loss selling season ends.

Our investment advice: don’t let tax considerations spur you to make a costly mistake. You can always sell next year and carry your loss back.

As a member of TSI Network, you may have already seen Capital Gains Canada: 7 Secrets for Managing Your Canadian Capital Gains Tax Liabilities. If you haven’t yet read this free report, click here to download your copy today.