Tax-loss selling gains momentum toward year’s end, but is it worth it for investors?

Tax-loss selling occurs when you sell a security at a loss in order to use that loss to offset capital gains in Canada. By using these losses to offset your taxable capital gain, you can save on income tax.

However, tax-loss selling is vastly overrated as an investment tactic, now more than ever.

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A tax-loss selling strategy makes more sense when interest rates are high

Decades ago, when interest rates were much higher, tax-loss selling made more financial sense. Back then, if you cut your capital-gains tax by selling losers, you could use the extra cash to generate safe returns of 5% to 8% or more. Now, safe returns are under 2%.

If you sell a losing stock, the best tax recovery you can make is (about) 25% of your loss, minus commissions. That’s because the tax benefit of selling is to cut your taxable capital gains by the amount of your “nailed-down” or realized capital losses. Capital gains are taxed at half the marginal rate that you pay on ordinary income. The top tax rate on ordinary income is now 50%, so the top capital-gains tax rate is 25% of your gross gain.

On the other hand, if the stock goes back up to what you paid, you recover 100% of your loss. Better yet, this gain is tax free, since it only gets you back to where you started.

Don’t take it personally…

Before you sell a stock that went down, ask yourself if you feel a tiny bit hurt or betrayed that it let you down by falling after you bought it. For that matter, be honest with yourself if you feel an urge to buy more of a stock you own, just because it fell after you bought it. Refusing to admit a mistake is always a bad habit, but especially in the stock market.

Above all, stay out of the investor trap that says you have to build your portfolio so that every one of your stocks goes up. If they all go up, it may mean you failed to diversify. All your stocks may operate in the same economic sector, or are highly cyclical, or under the influence of a single outside variable.

This can be great fun while it lasts—while that overwhelming outside factor is working in your favour. But it’s sure to lead to severe losses when the trend turns against you.

An important rule to follow with tax-loss selling

If you consider making use of tax-loss selling to minimize capital gains in Canada, you should also be aware of the “superficial loss rule.” This rule states that if an investor, their spouse or a company they control, buys back a stock or mutual fund within 30 days of selling it, then they are not permitted to claim the capital loss for tax purposes. Failing to obey the 30-day rule will result in the capital loss being disallowed.

There are some ways to keep exposure to stocks during the 30-day period. For example, if you decide to sell your resource shares to realize a capital loss, but then you decide that resource stocks are poised for a rebound, you can buy a resource-heavy exchange-traded fund (ETF) 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 (such as selling TransCanada Corp. and buying Canadian Utilities).

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 the stock back after 30 days (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.

It has become harder to identify stocks with potential buying opportunities for tax harvesting. How have you successfully picked stocks leading to profits with tax-loss selling?

Tax-loss selling isn’t the only way to get a tax break on your investments. What is your preferred way to get a tax advantage?