When December rolls around it is time to look over the portfolio and see where certain holdings are in a significant net loss position to decide whether it is time to lock in the loss to offset against current year or past year capital gains (past year because losses can be carried back or appllied against gains up to three years in the past to reduce taxes and get a refund). The objective is to reduce net capital gains to reduce taxes.
In looking over my own holdings, as shown in the model portfolio at the bottom of this blog, just about everything is showing a loss since I remodelled the portfolio in May and booked a pile of capital gains. Lesson number one is therefore to keep a running total of capital gains to be able to tell at any moment whether it is necessary or advisable to do any tax loss selling at all for this year's return. That's why I have my Cost Base tab in the model portfolio spreadsheet, which I update with every trade. Note that capital losses can be carried forward indefinitely into future years so if you think you may have higher income down the road, it may be beneficial to take a loss now to offset future higher gains. For the passive index investor, present market difficulties and losses presents an opportunity to lock in those losses with the confidence and expectation that sectors / asset classes (e.g. REITs have taken a hammering) will eventually recover. The indefinite carry forward feature of CRA rules means that one doesn't have to try predicting when markets will recover, only that they eventually will recover (if they never do, we are all in deep trouble or if you die before they do, will you care?). Patience is a virtue.
First, I note that one holding - AGG, the US Intermediate Term Bond Fund - has gone up in price in US funds from $99.37 to $100.38 yet it shows a loss in Canadian dollar terms, which is what counts for Canadian tax purposes. The reason for that is, of course, the tremendous appreciation of the Canadian dollar vs the US dollar; in this case, the C$ has appreciated from about CAD1.0920 per USD on May 23 to about 1.0167 today (yup, that's right appreciation means it takes less CAD to buy USD). It is thus very worthwhile to track a portfolio taking into account the shifting exchange rate. Volatile exchange rates can easily and quickly change a net Canadian dollar gain into a loss (or vice versa).
However, most of my portfolio is held within my RRSP or my LIRAs so there is no chance to claim capital gains or losses. Two holdings are in my non-registered taxable portfolio - VV, Vanguard's US Equity Large Cap ETF and VNQ, Vanguard's US REIT ETF. In the case of these two holdings, the USD price loss has been accentuated by the falling USD, creating a significant enough opportunity to spend the commission costs to lock it in.
Note that the Canada Revenue Agency does not require, nor does it accept, the reporting of foreign exchange gains or losses of $200 or less (see page 18 of the CRA's Capital Gains guide T4037).
Note also that the date on which to do the foreign exchange calculation is the settlement date, when you receive the money from a sale, or pay the money for a purchase, NOT the trade date, which is three business days earlier. It is thus a fact of life that the exchange rate will shift, perhaps a lot, between the trade date and the settlement date, so you can never know exactly how much your gain or loss on foreign property will be. Well, perhaps if you had millions at stake it might be worth locking in the exchange rate with a foreign exchange futures transaction but for us hoi polloi, it won't be practical.
The settlement date rule is especially important to note when one is selling right at year end - if the trade date is in 2007 but the settlement date is in 2008, you cannot report the loss on your 2007 return, you must report that in your 2008 tax return, probably not what you want if you are trying to minimize taxes now. Due to normal holidays when exchanges are closed, this year the last trading day for counting transactions in 2007 is Dec.24th. Incidentally, I phoned CRA and asked for a reference to a written guide where this rule on the settlement date is stated but they had none to point me to except general statements like subsection 40.1 of the Income Tax Act which mentions gains or losses are counted when actual value is received.
Incidentally, there are of other things than ETFs to which tax loss selling applies and a good summary of tax loss selling by Kevin and Keith Greenard appeared in the Dec. 8, 2007, Victoria Times Colonist. As the Greenards point out, it is worthwhile to review capital agins reported in the last three years since present year losses can be carried back to offset past tax and obtain a refund.
One tip that can reduce your foreign capital gain or increase your capital loss by about 2% depends on the exchange rate that you use to convert to/from Canadian to US dollars (or other currencies if you are able to trade in such). The CRA accepts as standard the published Bank of Canada rates account and the funds had not passed into or out of actual CAD. Though they could not quote me a written source to confirm this and therefore there may be some doubt they misunderstood what I was asking, which might mean it is incorrect, such a position conforms to the logic of what a real trade would follow. but these are nominal mid-market (half-way between buy and sell) rates not the rate you or I pay to our broker to buy or sell. The commission charged by the brokerage means you get fewer USD when you buy them / buy the US equity, and less CAD when you sell. In the case of BMO Investorline, it's about 1% commission each way, or 2% for a round trip. The CRA told me when I called their public tax info line at 1-800-959-8281 that I could use the actual broker buy-sell rate, even though the purchase and/or sale may have occurred entirely within a USDCRA is not that unfair to force people to use FX rates that understate their costs or over-state their proceeds of sale. In other words, you and I are better off using the broker foreign exchange rate instead of the Bank of Canada rate . The only requirement is that you must document and be able to show the CRA, if they should ever ask, the actual broker rate. I simply took a screen shot image of the BMOInvestorline FX quote for the CAD-USD exchange on my settlement date. You must also use the same method of FX, Bank of Canada or broker rate, on reporting both original purchase and eventual sale. You don't have to follow the same method for all holdings, however - it can vary holding by holding.
Another key rule has to do with passive index ETFs (or mutual funds), identical properties and a superficial loss. If you want to sell for a tax loss but stay invested in the market in the same asset class, you must not buy an ETF that tracks the same index as the one you just sold for the loss. Otherwise, CRA will deny you the loss, i.e. deem it a superficial loss, and treat your transactions as if you had never sold the losing ETF (your adjusted cost base of the new ETF will be considered the same as the old one). That the practical interpretation of identical properties regarding ETFs is such is stated on pages 164-165 in Howard Atkinson's book on ETFs, the New Investment Frontier III (see my review of this book here). Jamie Golombek, with AIM Fund Management at the time, in a Canadian Tax Highlights March 2002 article referred to a Dec. 5, 2001 CRA bulletin (TI 2001-008038) that used the example of two funds which track the TSX 300 from different companies as being identical in CRA's view. I am still awaiting a response two weeks later to my enquiry to CRA's public info line on the matter to confirm this interpretation.
Update January 11, 2008 - a representative of CRA phoned and said that the 2001 bulletin mentioned above is the only and latest information on the subject. He also emailed me a copy. Some key excerpts: "... the determination of whether investment instruments are identical properties requires a review of all the facts of each particular situation which would include a review of the legal structure of the investment entity, the composition of its assets, risk factors, rights of investors and any relevant restrictions. ... a TSE 300 Index Fund, for example, would generally not be considered identical to a TSE 60 Index Fund. ... Accordingly, an investment in a TSE 300 index-based mutual fund of a financial institution would, in our view, generally be considered indentical to an investment in a TSE 300 index-based mutual fund of another financial institution."
In my case, VV tracks the MSCI US Prime Market 750 Index and I bought IVV, the iShares ETF that tracks the S&P 500 Index. By the CRA rule if I now try to sell the IVV and buy SPY, the SPDR S&P500 to lock in further losses (a hefty drop this week), that loss would be disallowed. The VNQ that I also sold tracks the Morgan Stanley REIT Index while my replacement fund, the RWR from SPDR tracks the DJ Wilshire REIT Index. That should not violate CRA's test while keeping me fully invested.
It is thus very handy to keep a list of alternative acceptable ETFs within each asset class, such as the one in the Asset Allocation tab at the bottom of this page. You should also note what index they track to comply with the identical properties rules when selling for tax losses. In my original off-line spreadsheet, I've added that info in the cell Notes, though unfortunately the Notes cannot be displayed in the Google on-line spreadsheet.