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Tax Loss Selling – Bargain Hunting for Stocks

Tax Loss SellingFor bargain hunters, “Black Friday” has become synonymous with big crowds and massive deals.  Retailers, forever trying to get an edge on one another, have also bought into (and fed) the mania that has now come to be known as the biggest pre-Christmas shopping bonanza of the year.  Is there an equivalent “discount season” for bargain hunters in the stock market?  There is…almost.

Canadian stocks are sometimes subject to a seasonal occurrence called “tax loss” selling, which tends to put stocks, especially those who’ve had a rough go during the year, on sale.  Tax loss selling typically starts taking place in November and December and can be a chance to pick up some bargains if you’re willing to do a bit of homework and planning.

The reason behind tax loss selling season is fairly straightforward.  Individuals, especially savvy investors, want to minimize their tax exposure (i.e. pay as little tax as possible). Taxes are a part of investing.  If you make money on an investment outside of a registered account, a portion of that money gets taxed (either as a capital gain or business income).  Because gains are taxable, if you have no gains then you aren’t taxed. One strategy to minimize gains is to offset them with losses.  But why would anyone take a loss just to avoid taxes?

The crux of the strategy rests on the idea that if there are losers in your portfolio that aren’t really going to do anything for you or that might represent “dead money”, it may be better to realize the loss than to keep “hanging in there”.  It becomes even more compelling to do so if you’ve realized a gain during the year for which you’re going to have to pay taxes on.  So, either way you take a hit – sell an asset at a loss or keep a losing asset, but pay tax on a winning one (assuming you have winners). The bottom line is that if the losing asset is just going to be a loser, the smarter hit to take is to get out of the loser and use the loss against any actual or potential gains.

There are a couple of rules that investors have to keep in mind when employing this kind of strategy.  The first rule to know is called the “superficial loss” rule.  For most investors, if you sell a stock at a loss and buy the same stock back within 30 days (regardless of the account you do so in), the Canada Revenue Agency (CRA) considers this to be “superficial loss” (see this link for the CRA article “What is a superficial loss?”). A capital loss cannot be claimed if the loss is considered a “superficial loss”.  Instead, if a stock is sold at a loss and bought back within 30 days, the adjusted cost base will need to be calculated.  The second rule to keep in mind is the deadline date in the calendar year for a sale to be considered for that tax year.  It can take up to three business days from the date a stock is sold for the actual trade to settle.  Because of statutory holidays in December (Christmas and Boxing Day) and weekends, the last day to execute the sale and have it count for this year (2012) would be December 24th.

When individuals start to sell en masse, the overall effect is depressed prices.  Typically, the underperformers are the ones on the chopping block and sometimes the selling is more enthusiastic than justified taking prices down below what the “market value” would be under “regular” conditions, thereby setting up the potential for bargains to be found. For more experienced investors, they typically prune their portfolios ahead of the year end selling in preparation for any bargains that might present themselves.

Getting to know the effect that investors can have on the market can give you a bit of an edge when looking for opportunities to invest. A cautionary note to take heed of is that often stocks that are either “cheap” or underperforming are doing so for a reason.  If much of the market has given up on the stock then going against the crowd can be a dangerous strategy.  As such, savvy investors typically do their homework in advance on who they are watching and wait for a good opportunity to step in.  To learn more about tax loss selling, here are three extra resources to read.

Globe and Mail – Investor’s almanac: How to harvest tax losses – (2011) – John Heinzl

Financial Post – Time to take your losses – (2011) – David Pett

The Blunt Bean Counter – Tax Loss Selling The 2012 Version – (2012) – Mark Goodfield

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