John Natale, LL.B., BComm, EPC, CFP
Head of Tax, Retirement & Estate Planning Services
John is the Head of the Tax, Retirement & Estate Planning Services, Wealth team at Manulife. He and his team provide case-level support on tax, retirement, and estate planning matters to advisors across the country.
Using capital losses to save taxes.
Down markets and negative rates of return are generally not good news. However, a potential silver lining is that realizing capital losses can reduce capital gains and taxes payable. 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 want 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 gain maximum 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.
An in-depth look at the issue ... and the opportunities
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. Many clients realized significant capital gains over the last three years, so this may be an opportunity to get back some of the taxes previously paid on those capital gains.
Usually, 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. For example, the earliest year allowed to carry back 2022 capital losses is 2019.
Transferring capital losses between spouses
Did you know that it’s possible to transfer capital losses between spouses? If a client doesn’t have capital gains this year or the previous three years but their spouse does, or if both parties have capital gains but the spouse is in a higher tax bracket, it may make sense to transfer capital losses to the spouse.
How does this work? Consider this example:
|Armando (Husband)||Margarita (Wife)|
|An investment he purchased for $60,000 has depreciated to $40,000||Has realized significant capital gains over the last three years|
|$20,000 capital loss position||Buys the exact same amount of the identical investment immediately after Armando sells his investment|
|No capital gains to offset the loss||Waits the minimum 31 days to sell the investment|
|He sells the investment to crystallize the capital loss||Under the superficial loss rules, Armando’s capital loss is transferred to Margarita|
The capital loss realized on Armando’s sale will be denied under the superficial loss rules and added to Margarita’s adjusted cost base (ACB) instead, thereby transferring the capital loss to her. This is because the superficial loss rules deny a capital loss when you or someone affiliated with you (e.g., your spouse) buys the identical property either 30 days before or after your sale AND that person still owns that identical property 30 days after your sale. This means that despite paying $40,000 for the investment, Margarita’s ACB is actually $60,000 ($40,000 purchase price + $20,000 capital loss denied under the superficial loss rules). Assuming for simplicity purposes, the investment doesn’t change in value while Margarita owns it for those 31 days, she will realize a $20,000 capital loss on the sale that she can use to offset her capital gains that year - or potentially carry back up to three years or forward indefinitely.
Important points to consider
When capital losses are carried back or forward, they reduce capital gains and taxes payable. However, capital losses carried back or forward don’t help when calculating eligibility for income tested benefits and tax credits like Old Age Security and the Age Amount because they are deducted after the income calculations on lines 23400 and 23600 on the income tax return, which are used to calculate eligibility for such items, respectively.
If an investment is purchased in a foreign currency, the ACB and proceeds of disposition must be converted to Canadian dollars at the time of the respective purchase and sale to calculate the capital gain or loss. Foreign currency fluctuations can have a significant impact on this calculation, so be careful before proceeding.
In terms of timing, the capital loss or gain is based on the settlement date and not the transaction or trade date. Settlement dates are usually two business days after a sale is initiated, thus the last day to tax-loss sell in a year will usually be at least two business days before December 31. If the plan is for the client to transfer capital losses to a spouse so the spouse can use the capital losses this year, then make sure the client sells their investment before the last full week of November, considering the spouse will need to wait for 31 days from that date before selling, to realize a capital loss in their own hands.
Investors in the following situation may be interested if they:
- 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.
The Canada Revenue Agency will then automatically apply the losses to the previous years requested on the form.
Remember that investment objectives and long-term goals trump short term tax considerations. However, if realizing a capital loss is consistent with your investment objectives, this strategy can save taxes. See our article on the superficial loss rules to ensure they don’t deny the capital loss. It includes strategies on how you can realize a capital loss but still stay invested in the market.
1 Includes a spouse or common-law partner as defined by the Income Tax Act (Canada).