Q

What's tax-loss harvesting?

A

It's a method for saving on taxes by unloading investments that have lost money.

So, what is it exactly? Tax-loss harvesting is one of those tricky concepts that seems insane at first. The idea is to purposely sell investments that have gone down in value so that you lose money. The reason? To save money on taxes!

You might be wondering why you’d do that. After all, the mutual fund that had decreased in value might rebound, but now you’ve sold it and you’ll miss out. It’s important to remember that tax-loss harvesting is a two-step process. The first step is to sell losing investments. The second step is to buy an investment that is pretty similar. That second step makes it likely that, if the market for the old investment goes back up, you’ll still reap the rewards with your new investment.

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Maybe we should say that it’s two steps plus an asterisk. And the asterisk is this: The investments you buy and sell can’t be too similar. If they are, it looks like you’re cheating the government out of the taxes you owe. If you sell an ETF that follows Canadian stocks on the Toronto Stock Exchange, you can buy another ETF that tracks Canadian stocks, but you’ll have to do it on a different exchange.

What are the pros? Aside from saving on your tax bill, tax-loss harvesting can increase your gains through the magic of compounding. You see, there is an argument that tax-loss harvesting is just a way to push your tax bill back a few years. If you pay later instead of now, you can make money off of the money you’d have otherwise turned over to Ottawa. It’s like a nice, interest-free loan from the government.

And the tax loss is mobile—you can apply it to the last three years or forward indefinitely. If you’ve got an investment property that you plan to sell and you know there’ll be a huge capital gains tax bill coming up, tax-loss harvesting now when the markets are down means new, cheaper investments purchased today and a nice tax credit that can be used in the future.

Is there anything to be careful about? Don’t do this in your TFSA or RRSP! As neither of these accounts are subject to capital gains, performing tax-loss harvesting in these accounts results in…well, nothing. Since there is no capital loss from these accounts, there’s nothing to apply to your capital gains tax bill.

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