Dan Bortolotti, CFP, CIM, is an associate portfolio manager at PWL Capital in Toronto. He is the creator of Canadian Couch Potato, an award-winning blog about index investing.
At this time every year, investors are encouraged to consider tax-loss harvesting. This strategy involves selling a security that has declined in value to claim the capital loss. This loss can then be used to offset capital gains incurred in the current year or the previous three years, or even carried forward to offset future gains. All of this can mean reducing your taxes – or at least deferring them.
Thing is, if you've built a portfolio from index funds or ETFs during the past few years, you may not have any losses to harvest. Indeed, equities have enjoyed such a long period of healthy returns that you're probably sitting on some large capital gains. You won't pay taxes until you sell these holdings and "realize" the gains, so it's usually wise to defer them. But there are times when harvesting your capital gains can be a better strategy. And while it doesn't have to be in December, this is when many investors are thinking about taxes, so it's as good a time as any.
Let's look at some situations when it can make sense to realize some of the gains that have built up in your portfolio.
You need to rebalance
Disciplined investors set targets for their asset allocation: For example, a balanced portfolio might be 40-per-cent bonds, 20-per-cent Canadian stocks, and 40-per-cent foreign stocks. If your portfolio drifts far away from these targets, then it's time to rebalance by selling some winners and using the proceeds to prop up the laggards.
Equity returns have been so good over the past few years (and bond returns comparatively low) that many portfolios are overweighted in US and international stocks these days. Rebalancing may require you to sell some foreign equities, and if you do this in a non-registered account you'll realize some capital gains. But rebalancing is important for risk management, so if your portfolio is out of whack, you should do it even if it triggers some additional taxes.
You have unused capital losses
Realizing gains can also be appropriate if you have unused net capital losses from previous years. This might be the case if you made some unfortunate stock picks in the past, or if you took advantage of earlier tax-loss harvesting opportunities as they came up.
Your total amount of unused net capital losses will appear on your Notice of Assessment, and if you have online access to your CRA file you can even go back and look at the year-by-year history of gains and losses you reported on your tax returns.
If you are planning to rebalance your portfolio by selling some winners, offsetting these gains with carried-forward losses makes this a no-brainer. Unused losses also provide an opportunity to tidy up your portfolio by selling stocks or funds that have large capital gains but are no longer appropriate because they're too risky or too expensive.
You're temporarily in a lower tax bracket
Deferring capital gains gives you the flexibility to realize them when you're in a lower tax bracket in retirement. But you might find yourself in a position where realizing gains now can result in a lower tax bill.
Say you normally earn a six-figure salary, but you were on parental leave or sabbatical in 2017 and earned much less than that. Since you'll be in an unusually low tax bracket this year, it might be a good idea to realize any capital gains that have built up in your portfolio. (You can buy back the same securities immediately if you want to.) If you wait until you're earning your full salary again, those gains could eventually be taxed at a much higher rate.
You want to give to charity
The holidays are the time for giving, and if you have unrealized gains in your portfolio, there's an opportunity to help your favourite charity and get a nice tax break as well.
When you make an in-kind donation of shares (whether a stock, ETF or mutual fund), not only can you claim the charitable tax credit on the full market value, but you do not have to pay tax on any capital gains that have accrued on the security.
Consider an investor who put $5,000 in an ETF tracking the S&P 500 five years ago. That holding would be worth about $9,200 today. If that investor donates the shares to charity, she would receive a tax credit of more than $2,000, while also avoiding taxes on the $4,200 capital gain she would have faced had she sold the shares. That's enough to turn any Scrooge into a philanthropist.
You're taking money out of your corporation
If you're an incorporated professional who is drawing salary or dividends to fund your regular living expenses, there's an even more compelling reason to realize capital gains in your corporate investment account.
Recall that in a personal account only half of a capital gain is taxable as income. In a corporate account the same is true, but there's an additional step. The untaxed half of the capital gain goes into what's called the capital dividend account. You can then make an election to CRA to withdrawn this money as a tax-free "capital dividend." That may allow you to reduce the amount of fully taxable salary or regular dividends you would otherwise withdraw.
As always, you should only consider strategies such as these after consulting an accountant or other tax specialist.