"You need MORE combines, dammit." -- The John Deere Corporation

“You need MORE combines, dammit.” — The John Deere Corporation

I was recently introduced to a pretty cool concept called tax loss harvesting. It’s not nearly as cool as me in a leather jacket with my hair slicked back (ONE AT A TIME LADIES), but hey. We all gotta start somewhere.

Let’s take a closer look.

The skinny

One of the most underrated skills in running a portfolio is using tax losses. Tax loss selling doesn’t get much attention because most investors don’t have much at all outside of their RRSPs and TFSAs, which means it’s all but useless to them.

But it can be really useful in your taxable account. Say you’ve got two investments that originally cost you $10,000, because you’re a baller. The one goes up 50%, while the other one falls 50%. Essentially, you’ve only broken even. Still, you’ll probably brag about the winner.

Many investors wouldn’t even bother thinking about the one that went down, and be happy to take their 50% gain on the one that goes up. But since we’re talking taxable accounts here, you’re looking at paying taxes on that gain. Because it’s capital gains, your approximate taxes would be $625.00. Not bad on a $5,000 gain, but if you’re anything like me, you’ll want to get that tax bill down. NO HARPIE THAT’S MY MONEY NOT YOURS.

There’s an easy way to do so. By selling your 50% loser and your 50% gainer, you’ll effectively pay no taxes. You’ll have an equivalent capital loss to go with the gain.

But what if you’re still bullish on the stock that went down? It turns out you can still take the loss and then buy the stock back, as long as you wait 31 days to do so. Yes, a lot can happen in 31 days, but remember the old ‘bird in the hand’ expression. A tax loss now is worth more than a potential gain in the future. And even if you miss out, there are a billion other investments out there. Even Bombardier.

How tax loss harvesting works

Tax loss harvesting follows that same concept, but in a cooler way.

The easiest example is to use ETFs. Say you wanted to own the TSX Composite index. You’d have a few options that are essentially identical:

  • iShares S&P TSX Capped Composite Index (management fee 0.05%)
  • BMO S&P TSX Capped Composite Index (management fee 0.05%)
  • Vanguard¬†FTSE Canada Index ETF (management fee 0.05%)

I’m beginning to detect a theme here.

Each of those follows the same index, it’s just that the Vanguard one is slightly different. Essentially though, they’re close enough to the same thing for our purpose here.

So here’s how the tax loss harvesting happens. Say you invest in the first TSX Composite ETF, and you have terrible timing. It falls 10% just a few weeks after you buy it.

Instead of just holding it and being patient–LIKE A CHUMP AND/OR CHUMPETTE–you take that bad boy and punt it out of the portfolio. You buy one of the other identical ETFs and call it a day.

(Edit: You have to make sure the two investments track different indexes. So switch up the TSX Composite ones with the TSX 60 ones. They’re 80% the same anyway.)

All you’ve done is switched up an investment for a (edit: nearly) identical substitute. By doing so, you’ve locked into place a tax loss, all at the cost of very minimal commissions. If you’re a Questrade client, you’ll just pay for selling the ETF and that’s it. The two buys will be free.

And that’s it. That’s how easy tax loss harvesting is. You’ll need to eventually have gains to offset those losses, but I’m sure that shouldn’t be too difficult. Remember, you can’t use capital losses to offset anything but capital gains. No writing off your dividends against the capital loss.

There are dozens of ways you can do this. If you’re not interested in the TSX Composite, feel free to do a similar strategy using the TSX 60, the U.S. market, Canada’s REIT or energy sectors, or even bonds if you’re a little nervous about that whole area. As long as they’re not identical indexes, you’re in business. You can even do it with individual companies, especially those sectors that tend to trade on sector-related news.

Take a look at this five-year chart of Canada’s largest banks and tell me they aren’t pretty strongly correlated.

Screen Shot 2015-08-10 at 10.42.00 AM

(Aside: go National Bank. I would have never thought it was the best performer over the last five years)

Tax loss harvesting is a simple concept, one that can really help the average portfolio outside of a RRSP or TFSA. For the average investor looking to hold over the long-term, I think it makes all sorts of sense. It’s a nice compromise for people who are nervous about the stock market now but don’t want to sit in cash.

Tell everyone, yo!