Tax Loss Harvesting using ETFs
With the end of 2023 approaching, ETFs can help investors manage their tax bills through tax-loss harvesting.
With the 2023 calendar year coming to a close, investors are beginning to assess how their portfolio has performed and determine which security holdings have been contributors or detractors towards overall performance. While no investor wants to incur losses, investors are able to make beneficial use of losses incurred to offset some realized capital gains taxes by harvesting investment losses.
Tax Loss Harvesting
Tax-loss harvesting involves selling a security with a capital loss to offset realized capital gains, which reduces a client’s tax liability; this benefit can be carried back three years or carried forward indefinitely. For investors that decide to sell a particular holding, but still want to have the exposure the security provided, they can be replaced with similar but not substantially identical securities to maintain a similar risk/return profile.
Using ETFs within One’s Tax Loss Harvesting Strategy
One common tax-loss harvesting strategy is to sell an individual stock that has incurred losses and replace it with an ETF that provides exposure to the same asset class, and often a similar segment of that asset class. A simple example being, selling the stock of a US Small-Cap technology company, and then replacing it with a US Small-Cap technology ETF.
Implementing tax-loss harvesting in this way can achieve several goals, including generating losses to offset gains, potentially reducing the overall risk exposure of your portfolio (by reducing exposure to individual investments), and avoiding a superficial loss. Thus, the ETF provides a sector-specific return in place of the stock. The superficial loss rules require investors to wait at least 30 days after the sale to repurchase the security. The same goes for anyone considered an “affiliated person” to the client, such as a spouse or common-law partner.
Even when using a tax loss harvesting strategy for their ETF holdings investors should have a clear understanding of what is allowable to not run afoul of any rules. For example, if an investor decides to replace ETF holdings they sold at a loss with a new ETF, they need to ensure that they are not considered identical properties according to the Canada Revenue Agency, in that, they are deemed to be properties which are the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another. To state plainly, if an investor replaces an emerging markets ETF from one fund issuer, with that of another, yet both funds have underlying securities that are identical, the superficial loss rule may apply. To safeguard against this, it is recommended that the two ETFs have similar but different underlying securities and follow different benchmarks so that they are not considered identical for purposes of the superficial loss rule.
To recognize a capital loss in calendar 2023, the last day for tax-loss selling is December 27 so that the trade settles before the year-end.
Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.
