A reader had a question about claiming capital losses in a non-registered account and why you would want to avoid the superficial loss rule (which states that if you sell something at a loss and then buy it right back within 30 days you are not allowed to claim the capital loss for tax purposes). It’s best demonstrated with an example with explanations along the way. We will assume a fictitious 50% tax bracket to make the math easy.
Let’s say we bought 1 share of company ABC for $5000. It later loses value over the year and is now only trading at $3000. Let’s assume we sell this share now for $3000. Let’s further look at buying it back at $3000 within 30 days and buying it back at $3000 after 30 days (obviously the stock will not just wait around to be bought at the price we want, so understand that this is for demonstrative purposes). Finally, we will assume that ABC increases to $6000 later on and we will sell it at that time.
We Immediately Buy It Back
In this case we are not allowed to claim the capital loss because the superficial loss rules apply, but we can add the loss to the adjusted cost base. We have a new investment with a cost base of $3000 + $2000 = $5000. When we eventually sell it for $6000 we now have a capital gain of $1000. The “taxable capital gain” is 1/2 of your capital gain which means that 1/2 of $1000 is subject to tax. $500 multiplied by the Marginal Tax Rate of 50% means we pay $250 in tax in this case.
If we did not sell the stock and just held it from $5000 to $6000, we would have had a capital gain of $1000, a taxable capital gain of $500 and tax payable of $250. The same result. What’s the big deal about avoiding the superficial loss rules you say??? Read on.
We Wait 31 Days Before Buying It Back
In this case we now have the ability to claim the capital loss. The “allowable capital loss” is 50% of the capital loss. This means the “allowable capital loss” is $1000. This allowable capital loss can be used to offset taxable capital gains in the year the disposition was made and up to three calendar tax years prior or carried forward indefinitely.
When we re-purchase ABC at $3000 after 30 days and then later sell it at $6000 again we have a capital gain of $3000, and a taxable capital gain of $1500. The taxable capital gain can be reduced by the $1000 allowable capital loss for a total taxable capital gain of $500. When multiplied by the Marginal Tax Rate of 50% we find that in this case only $250 of tax is owing. Wait a sec, this is the same tax payable as above. So really, what’s the big deal?
The Big Deal
The big deal is that by avoiding the superficial loss rules you can save money in tax today AND/OR in the future as opposed to only in the future if you trigger the superficial loss rule.
By being allowed to claim the loss you have more flexibility as to the timing of your tax savings.
Disclaimer: Check with a tax professional before making any financial decisions based on anything written by me (a NON tax professional!). Ditto with investing and other planning information I write. I reserve the right to be wrong. Always look both ways before crossing the street and for heaven’s sake don’t eat yellow snow! :P