Tax-loss selling comes with a raft of potential benefits, but it nevertheless has some strings attached — deadlines, for example.
Editor’s note — This article has been updated with the correct 2020 deadline for US tax-loss selling.
As 2020 comes to a close, investors may want to consider looking at tax-loss selling and how they can use the strategy to their benefit.
Buying stocks low and selling them high is ideal, but sometimes investments go sour. In such cases, all hope is not lost — at the end of the year, investors have the option of selling investments that provided losses instead of capital gains.
The money made from selling off losses can then be used to offset capital gains made throughout the year. This is the principle behind tax-loss selling.
The strategy is more appealing than usual this year — according to the Wall Street Journal, 2020 “is the kind of year that was made for tax-loss harvesting.” That’s because the market experienced a steep drop off in March followed by a “recovery to record highs.” So let’s take a look at how tax-loss selling works.
How does tax-loss selling work?
Tax-loss selling is the process of selling stocks at a loss in order to reduce the capital gains earned on an investment. Since capital losses are tax deductible, these losses can be used to offset any capital gains and reduce an investor’s tax liability on their tax return.
As an example of tax-loss selling for tax savings, imagine if an investor bought 1,000 shares of a company for US$53 each — they could sell the shares and take a loss of US$3,000 in the event that the shares declined in value to US$50 each. The US$3,000 loss from the sale could then be used to offset gains elsewhere in the investor’s portfolio during that tax year.
Tax-loss selling, or loss harvesting as some call it, generally involves investments related to huge losses, and because of this, these sales generally focus on a relatively small number of securities within the public markets. However, it’s important to be aware that if a large number of sellers were to execute a sell order in tandem, the price of the securities would fall.
It’s also worth noting that once selling season has come to a close, shares that have become largely oversold have an opportunity to bounce back. In addition, the fact that tax-loss selling often occurs in November and December — during a time when investors are actively trying to realize capital losses for the upcoming income tax season — the most attractive securities for tax selling are investments that are most likely to generate strong capital gains early in the next year.
As a result, a potentially beneficial strategy for investors would be to buy during the selling season and sell after the tax-loss has been established. This strategy could be used on either long-term capital gains or short-term capital gains.
Some investors may consider selling an asset at a loss, deducting that loss for a tax gain and then turning around and purchasing the same stock again in an effort to evade taxes — this is known as a wash sale. However, wash sales are prohibited by the Internal Revenue Service (IRS); if the IRS deems a transaction to be a wash, the investor would not be allowed any tax benefits.
To avoid this situation, investors must wait 30 days to repurchase shares that were originally sold for a loss. Additionally, shares sold for a loss must have been in the investor’s possession for over 30 days.
Important dates to save in 2020
Tax-loss selling comes with many potential benefits, but it nevertheless has some strings attached. The key thing for investors to remember is that it has deadlines.
For Canada, the last day for tax-loss selling in 2020 is December 29. Stocks purchased or sold after this date will be settled in 2021, so any capital gains or losses will apply to the 2021 tax year.
The system differs in the US, and based on information from the IRS, the last day for tax-loss selling this year is December 31.
Investors should always consult with an expert or review relevant tax documents directly for complete answers. This should not be considered tax advice.
The flip side of tax-loss selling
On the flip side, investors should be aware that as tax-loss selling gets underway, opportunities also tend to open up for those who have spent the year on the sidelines.
In her piece “How Bout Tax Loss Buying?,” Gwen Preston, publisher of the Resource Maven newsletter, explains that Canaccord Genuity (TSX:CF,OTC Pink:CCORF) has found that from mid-November to mid-December, S&P/TSX Composite Index (INDEXTSI:OSPTX) stocks down more than 15 percent year-to-date underperform the index by nearly 4 percent. However, from mid-December to mid-January, those same stocks outperform the index by 3.6 percent.
“That outperformance is on top of gains the TSX reliably generates over that time frame,” Preston states. “So instead of only seeing tax-loss selling as a time to generate tax credits by dumping dogs, let’s look at the opportunity to profit.” You can watch her video on this topic below:
Watch Gwen Preston of Resource Maven discuss tax-loss selling.
How to time selling
Regardless of whether you’re buying or selling, Steve DiGregorio, portfolio manager at Canoe Financial, recommends that you act swiftly and aggressively as “liquidity will dry up.” DiGregorio earmarks the second and third week of December as the ideal window to sell or buy at a low point.
This is well ahead of the “Santa Claus rally” — the period around the last week of December when stocks tend to rise ahead of a healthier market in January.
For now, the year isn’t over yet, so whether you’re tax-loss selling or buying, there’s still time to talk to your accountant or financial advisor to determine which approach is best for you.
This is an updated version of an article first published by the Investing News Network in 2014.
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Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.