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Markets have faced waves of volatility this year, which means some investors may find themselves experiencing capital losses in their portfolio. One way to manage those losses is through tax-loss selling. Kim Parlee speaks with Nicole Ewing, Director of Tax and Estate Planning at TD Wealth, about the do’s and don’ts to keep in mind.
Kim Parlee: Let’s just start with what tax loss selling is.
Nicole Ewing: So at its core, it’s essentially– if you have an investment that is — the fair market value is now below what its cost was, we sell that at a loss, and we can use those losses to offset capital gains, essentially reducing your overall tax bill. So we’re using our allowable capital losses against our taxable capital gains and, ultimately, we don’t pay this high rate of tax.
Kim Parlee: Right. Less tax. Less tax good. More tax bad. You have compiled a very good list of dos and don’ts. So let’s start with the don’t, and number one don’t is don’t forget the deadline.
Nicole Ewing: Don’t forget the deadline because the deadline is December 31 from a tax perspective, but we need time for those transactions to close. And so it’s going to be a few days. We generally say December 28 is really pushing it. Now you should recognize what your loss is– what your gains are. Your tax strategy should really be finalized around now. So there’s no reason to be waiting for that last minute. So December 28, absolutely last possible time.
Kim Parlee: Okay. Second one is don’t let the tax wag the dog– tax tail wag the dog.
Nicole Ewing: Don’t let the tax tail wag the dog. Tax is critically important. We always want to be thinking about it when we’re looking at our strategies, but we don’t want to be doing things simply because it’s tax effective. We need to step back, look again at what our overall strategy is. We might be doing something for tax purposes that could actually undermine some of the other planning that we’re doing. So don’t just blindly go because we’re getting a tax benefit. Make sure that we’re considering the plan.
Kim Parlee: Got it. The big picture is always important. Next one is don’t forget to factor in the exchange rate, which changes, as it does.
Nicole Ewing: Yes. This is a big one because if you purchased your securities when the dollar was at a different value against a foreign currency — so if we’re looking at the US, you might be in a loss position if you’re looking solely at the price of the stock, but once you factor in the difference from the time that you purchased it till now with that exchange rate, you may actually be crystallizing a gain inadvertently. So we need to look at that stock and use the price– the true price of it, which includes the foreign exchange.
Kim Parlee: So the exchange rate when you bought it versus exchange rate when you plan to sell it. That would be unfortunate when you’re expecting a loss, and then– yeah.
Nicole Ewing: We can think about that somebody might have purchased this– might been having holding on to it for 20 years or more when exchange rates were very different. So make sure that you’re factoring that in.
Kim Parlee: Next one is don’t forget about bonds.
Nicole Ewing: Bonds–
Kim Parlee: Especially this year.
Nicole Ewing: Well, and this is something that wouldn’t typically be on our radar. We wouldn’t really be looking at bonds for our losses, but certainly now with the rates rising, there is an opportunity to sell some of our bonds, perhaps replace those with others that will give us a better result. And so, yes. Just make sure that you’re considering those as well.
Kim Parlee: Got it. Don’t forget about the superficial loss rule. Let’s spend a little time on this because this matters.
Nicole Ewing: Yeah, it does matter. It’s something that people don’t necessarily think about. Many people know the first part of the rule. So the first part of the rule is, if you have sold your stock– sold your security and you have a loss on that, if you repurchase that same security within 30 days or if you purchased it 30 days ago and sold it within that time period, your loss is going to be denied.
And will forever be denied. It will eventually be added on to your cost base when you sell the new securities, but we need to be aware that we can’t be buying and selling in that short time frame. What people often miss is that this applies to associated persons. So if my spouse sells or purchases that stock, if a corporation that I’m in control of, a partnership, all of those are–
Kim Parlee: Related.
Nicole Ewing: –related. So if my spouse purchases and I sell, my loss might be denied because of what they did. So coordination very important.
Kim Parlee: I bet you a lot of people miss that one, especially between spouses.
Nicole Ewing: I expect they do. Yes. Yes.
Kim Parlee: And the next one is don’t just think about your situation this year, think about multi-year planning.
Nicole Ewing: And when we look at capital losses– so we can carry them back three years. So if we had gains in the previous few years, we might want to think about carrying them back or we can carry them forward into the future indefinitely. And so when we’re looking at tax strategies, we don’t want to be looking in a vacuum at a one-year time frame. We want to think about what we can do over multiple years. It’s really going to give us the best result, overall. So we want to look at our income, what we’re expecting this year, next year, look at our capital gains, what we expect to be realizing, and have that strategy, not just for this year, but for a few.
Kim Parlee: And I’m sure if people have the opportunity, if they have a loss that they can apply to years past. I mean, yes, one is kind of bird in the hand versus what you’re planning to actually what could happen, right?
Nicole Ewing: Yeah. Exactly.
Kim Parlee: It’s a tricky one. Do coordinate with your accountant and financial advisors. Make sure everybody is talking to everybody.
Nicole Ewing: It’s so important because we see this, particularly, when we’re dealing with corporations, for example. And if you’re selling your investments within your corporation, you need to be mindful of the capital dividend account– so the capital dividend account, the notional account that allows the corporation to pay out to a dividend to a shareholder tax-free.
What happens with the capital dividend account when you realize a loss is it reduces that. So timing is going to be very important. If we have a positive balance in our capital dividend account, we want to be paying that out before we’re crystallizing those losses. So we have a gain. We’re going to look at our capital dividend account, see if we can get some money out to our shareholders tax-free before we’re going to do that loss.
Otherwise it’s a use it or lose it type of account. So it goes up and down. This is essentially the non– when we sell the capital, we have a capital gain there’s that non-taxable portion. In the corporation, this is where that goes. So that non-taxable portion goes into this notional account. It would be a real shame [LAUGHS] if we lost that ability to get those funds out tax-free simply because we did things in the wrong order.
Kim Parlee: And tell me with that one, too, exactly who does that apply most to? Like who are the generally the users of that type of account, and I’m sure families and businesses. But what where do you see it used the most?
Nicole Ewing: There’s a lot of different ways that you might see it. It could be in operating companies, but in a holding company, if, for example, if somebody had passed away and insurance was paid into the corporation, that’s going to be credited to the capital dividend account.
And so a lot of small business owners, a lot of those who might have holding companies, for example, it really can be a broad application. So we want to make sure that we’re really understanding what that balance is, and do we even have one?
And what we need to do is coordinate with our accountants. Make sure that they’re the ones telling us because they are the ones who are going to know what they plan to do. So getting everybody on the same page, making sure that we have that strategy in place, and that everybody’s executing it. We don’t want to be doing last minute panicky things– again, the wag the dog. Yeah, let’s get it in quickly. Step back, get the professionals involved, and make sure that everybody is on the same page.
Kim Parlee: Nicole, thank you.
Nicole Ewing: Oh, my pleasure.
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