Profiting from tax-loss selling

5iResearch analyst Moez Mahraz stresses any benefit from tax-loss selling is of secondary importance to the long-term benefit of investing in quality stocks in the first place.

As we approach the end of the year, many investors begin to take advantage of a common practice in investing—tax-loss selling. This is a chance for investors to ‘benefit’ from stocks that have not performed so well throughout the year by claiming capital losses in their non-registered accounts, in turn reducing their capital gains tax. In addition to this, unused capital losses can be carried back up to three years or carried forward indefinitely.

Small-cap stocks in particular are usually the most affected by tax-loss selling. This is due to a combination of two factors:

■ They have a larger retail ownership base who invest using their non-registered accounts.

■ Smaller companies tend to be less liquid and can be more impacted by broad-based selling.

Large-cap stocks are not as affected by tax-loss selling since they are generally seen as ‘more stable’ than small-caps, resulting in less sensitivity to price movements.

Following the sale of these ‘losing’ stocks, many long-term investors may choose to re-invest in those same stocks at the beginning of the year if they continue to show good fundamentals and have strong prospects for the future. After all, even the best of companies can have a bad year. Writing off good companies based on one year of bad performance has proven to be a source of regret for many investors.

The benefits of tax-loss selling

Deciding how much to claim in capital losses for tax-loss purposes will vary from person to person and is best discussed with your accountant. To illustrate how effective tax-loss selling can be, take the following example:

If you have realized capital gains of $20,000 in 2019 and have a marginal tax rate of 29 per cent, then your capital gains tax bill will be $2,900 ($20,000 x50% x 29%). However, if you have $15,000 in realized capital losses and chose to use $10,000 of those losses in 2019, then your capital gains tax bill is essentially halved to $1,450 (($20,000-$10,000) x 50 per cent x 29 per cent). You will have $5,000 in losses left over to use in future years (or even apply to three preceding years). Put in return terms, this $1,450 in savings represents 1.45 per cent in additional return in a $100,000 portfolio.

Telling good tax-loss candidates from bad ones

If you already own a stock that is a tax-loss candidate, the portfolio decision is more nuanced compared with someone who is looking at buying a new stock that has been unjustly pushed down after tax-loss season. If you are holding a company at a loss, it does not always mean it is a good idea to sell. Volatility is also important to consider. Remember, an investor has to wait 30 days before buying the stock again for it to be considered a capital loss that is eligible to offset the gain.

A quick move in the stock can easily offset the tax benefit. If you see that the company has good long-term prospects, but has a history of moving five per cent in one day, it may be a good idea to hold on to that company because it is difficult to gauge where the price will be a month from now. Selling can result in missed out long-term returns if sold at the wrong time and bought again at a higher price (if one buys back in at all).

Companies that are likely good tax-loss candidates are companies that you know have a negative and are not likely to repurchase or companies that are more stable with solid fundamentals but have had a bad year in the markets and are less likely to see a big move in a short period (such as a telco for example). Cannabis stocks could be candidates for tax-loss selling, but the ‘savings’ from tax-loss sales could be recouped or wiped out in a single day due to the volatility of these stocks.

A final point we would emphasize here is that any benefit from tax-loss selling is of secondary importance when compared to the long-term benefits of investing in a company with sound fundamentals. Therefore, tax-loss selling should not form the basis of major investment decisions. Often, investors can spend too much time figuring out how to save on taxes only to get back a small amount in the grand scheme of things (our example above gives an idea of what investors can expect). We think time is better spent more on understanding companies, as good companies end up being much more rewarding in the long-run.

Moez Mahraz is an analyst at 5iResearch.

This is an edited version of an article that was originally published for subscribers in the November 2019/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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