The chimera of tax-loss harvesting
“April is the cruelest month,” wrote T.S. Eliot in his poem The Wasteland. This may well be true of the desolate Wasteland. But it can also be true in the real world - for April is the month when most Canadians prepare and submit their tax returns.
A good portion of tax filers will seek relief by applying the technique known as tax-loss harvesting. It seems like a clever way to reduce taxes. But this view is questionable: when you think about it, there may not be any benefit.
Tax-loss harvesting involves selling a taxable investment with a capital loss and repurchasing it after the 30-day superficial-loss rule, or else immediately buying a different, but correlated, investment. The capital loss is then claimed against capital gains to reduce taxes.
In reality, his strategy merely defers tax to future periods and leaves after-tax returns unchanged over the long run, ceteris paribus . That’s because tax-loss harvesting re-sets the price of the investment to a lower level. So when the time comes to dispose of the holding for good, the reported capital gain will be bigger than if the investor had just bought and held. The extra tax on this bigger gain offsets the tax reduction derived from the tax-loss sale.
Consider an investor in the 33% tax bracket who puts $100,000 into an investment fund held in a taxable account. It declines to $70,000 but rebounds over the ensuing years to $140,000, where it is sold to help fund retirement.
The buy-and-hold investor pays tax on a capital gain of $40,000, which amounts to $6,600 ($40,000/2 x 0.33).
But the tax-harvesting investor first sells at $70,000 to claim a capital loss and receive a tax refund of $4,950 ($30,000/2 x 0.33). Then they sell at $140,000, realizing a capital gain of $70,000 on which tax paid is $11,550 ($70,000/2 x 0.33). Netting out the earlier tax refund, final tax paid is $6,600—the same as the investor who held throughout.
Thus, tax is only deferred. Some investors may still be attracted to tax-loss harvesting because it’s like getting an interest-free loan that is paid off in inflation-depreciated dollars. But when interest rates and inflation are at low levels, this benefit is rather small.
Even if interest rates and inflation are high and the benefit is larger, there is a material risk that tax rates will go up in the interval between a tax-loss sale and a sale to fund retirement. If this happens, tax-loss harvesting will result in paying more taxes than simply buying and holding.
To demonstrate, let’s say the tax rate in the above example rises to 50% after the tax-loss sale. When the position is closed for good by the tax-loss harvester at $140,000, gross tax paid is $17,500 ($70,000/2 x 0.5), leaving net tax of $12,550 after deducting the earlier tax saving. The buy-and-hold investor, however, ends up paying lesser taxes of $10,000 ($40,000/2 x 0.5).
The risk of higher tax rates should not be underestimated. Federal and provincial governments these days are running large deficits and accumulating large debt burdens. At some point in the future, they may resort to taxing capital gains at higher rates to meet their onerous financial obligations, which seem to always be escalating.
There may be some situations where the benefits of tax-loss selling are clear, like when an investor knows with certainty their income will drop into a lower tax bracket in the future. Or they are donating to charity. But for many investors, the benefits of tax-loss harvesting could turn out to be a lot less than expected.