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One of the biggest sources of drag for investment portfolios in non-tax advantaged accounts (e.g. not TFSA's, RRSP's, LIRA's, etc.) is capital gains tax. To recap, when you sell an investment for a profit, capital gains tax is applied.

For Canadians, 50% of the value of any capital gains is taxable at your ordinary-income rate (which of course, depends on how much you make and what tax bracket you fall into). 

This isn’t ideal. I won’t get into the whole argument of whether taxes are good or bad. For the purpose of this discussion, let’s assume you want to pay as little capital gains tax as possible. Legally, of course. 

This is where tax-lost harvesting comes in. 

What is Tax-Loss Harvesting?

We’ve established that capital gains tax is payable when you make a profit after selling an investment. The opposite is also true. If you sold an investment below your cost basis and incurred a capital loss, you can claim that as a tax credit to offset future capital gains. 

Capital losses can be used to reduce capital gains in the current year, the three preceding years, or in any future year. This can significantly boost your net returns and minimize the negative impact of losses in a taxable account. It can also be carried forward to reduce taxes in future years when you do plan to sell for a gain. 

Investors need to be aware of the "superficial loss" rule, which states that when you sell a security at a loss, you cannot repurchase the same security within 30 days. A way to get around this via ETFs is by buying a comparable ETF that tracks a different index with a high correlation and similar fees to your original one. 

Let's work through an example. 

Tax-Loss Harvesting Examples

Let’s assume that I invested $100,000 in the S&P/TSX 60 through the iShares S&P/TSX 60 Index ETF (XIU). A year later, a bear market has caused my investment to dwindle to $80,000. 

To tax-loss harvest, I sell all $80,000 of XIU and lock in a $20,000 capital to offset future capital gains. I then immediately reinvest the $80,000 into another ETF that tracks a different index than XIU but performs almost identically due to their similar holdings and fees. 

In this case, I chose the iShares Core S&P/TSX Capped Composite Index ETF (XIC). XIC is basically XIU with some mid and small-cap stocks added. The two have a 0.99 correlation. You can use the NEO ETF Screener to find similar ETFs for tax-loss harvesting pairs based on various criteria, such as geography, index, market cap, fees etc.

The result? I now have $20,000 worth of capital losses to carry forth or apply to previous years to offset capital gains, thus reducing my tax liability. My $80,000 position in XIC will recover nearly identically to XIU, so I didn’t have to spend 30 days waiting on the sidelines in cash. 

Here’s another example using stocks. If I was investing in the Big 6 bank stocks (like RY, TD, CIBC, BMO, BNS, NA), I could sell them for a loss and immediately purchase the BMO Equal Weight Banks Index ETF (ZEB), which holds all six stocks. 

Tax- Harvesting ETFs: Things To Note 

Keep in mind that the above-noted examples are hypothetical. To determine whether or not an ETF can legally be used to tax-loss harvest another holding, ensure you always consult a tax attorney or accountant. The information presented above is for general purposes only and should not be construed as legal or investment advice. 

There are other limitations too. First and most obvious, tax-lost harvesting only works in a taxable account. Doing this in a TFSA/RRSP does absolutely nothing. You can’t tax-harvest losses when there’s no capital gains tax to be paid. If you incur a loss in a TFSA/RRSP, the contribution room is lost forever, so think carefully before selling.

Finally, some always pertinent advice is “don’t let the tax tail wag the dog.” Tax loss-harvesting potential should be a secondary, not primary, consideration when selecting an ETF for your investment portfolio. While beneficial to consider, more pertinent factors include the fund’s expense ratio, level of diversification, assets under management, volatility, and strategy. 

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.