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Guidelines to Tax-Loss Selling - November 30th 2004



Once again the joyful season of tax-loss selling is upon us. Any stock trading below its 52-week high could potentially be a candidate for tax-loss selling and those trading near their 52-week low could definitely be affected. As a general rule of thumb, those that will likely come under the most selling pressure are those trading at a discount of at least 50% from the high set in the year.

 

Tax-loss season typically runs from mid-to-late November until the end of December. Of course, the severity of tax-loss selling is in direct proportion to the level of gains that investors have achieved during the year. When markets have performed well, investors are left scrambling at the end of the year trying to offset capital gains. On the flip side, tax-loss selling is generally light in poor investment years. With the Toronto Stock Exchange up 10% and the TSX Venture exchange break even to-date in 2004, I would expect this tax-loss season to be moderate.

 

A stock which is below its purchase price can be good in one respect – It can be used to offset gains in other stocks in order to minimize taxable capital gains for the year. Minimizing tax effects means greater capital to invest in the coming year which will hopefully lead to higher gains. Having a firm understanding of one’s trading account is crucial to taking advantage of tax-losses.

 

There is a psychological barrier to selling stocks in a loss (which is why technical analysis can be so accurate and useful). I’m sure every investor has thought that he/she will stubbornly hold a certain stock until it reaches its purchase price and will then sell. There is something in our mind that will simply not let us sell something at a loss. In my opinion this is a grave error on the part of many investors which often leads to further losses. In order to maximize gains, one has to remove emotions from the decision making process. Investors should ask themselves one simple question regardless of whether the stock they hold is in a loss, break-even, or gain. Would I buy this stock today at this price? If the answer is no then it is a prime candidate for sale. This is of course easier said than done even in my own investing.

 

Of course one has to consider all aspects of the decision making process, including fundamental and technical analysis, and future potential before determining whether to sell a stock for tax-loss purposes. While this is an effective strategy in any investment decision process, it is particularly helpful in removing emotions in order to sell loser stocks.

 

One of the key reasons for performing such an analysis on a stock by stock basis is that investors should be aware that many fundamentally strong stocks may post a significant recovery following tax-loss selling. Despite the strong fundamentals of these stocks, they may come under selling pressure late in the year if they are trading at a significant discount to their 52-week high. There is always a possibility that tax-loss selling may cause an unnecessary sell-off of certain shares, particularly in cases of less liquid stocks. Investors can actually take advantage of this situation if they have cash on hand to purchase stocks under undue tax-loss pressure. These stocks typically rebound in the pursuing weeks but keep in mind that this generally only works for those shares which are trading at a low valuation in comparison to fundamental data.

 

Tax-loss selling is subject to some taxation rules in Canada that investors need to be aware of. First of all, any stock sold for a loss cannot be repurchased in the 30 days following the sale. This is also true for those hoping to buy more stock in the 30 days preceding the sale. These actions negate the effects of the sale and are deemed to be artificial losses for taxation purposes. The only way to accomplish the sale for tax purposes and the subsequent repurchase is to sell a loser outside of an RRSP and repurchase the stock within an RRSP. Secondly, tax-losses can be applied to gains in the preceding three years and can be carried forward to be used in the future. Tax-losses carried back must always be applied to losses in the current year first.

 

For the 2004 taxation year, the last day to sell a stock for tax-loss purposes is December 24 (and this is likely to be a shortened trading session). Since trades take three days to settle and the markets are closed on December 27 and 28, any trades after December 24, 2004, will be accounted for in the 2005 taxation year.

Canadian Small Caps

 
Canadian Small Caps

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