As the end of the year approaches, many taxpayers and brokers will look to optimize the tax impact of investment portfolio gains and losses realized during the year. Part of this process involves deciding if there are any stocks which it is time to realize gains before the end of the year or perhaps to sell off losers to utilize losses or to shelter the tax impact of capital gains realized during the year.
For stocks that individuals hold in which they still “like” but have accrued losses associated with them, it can be tempting to try to realize the loss by selling the stock and then rebuy the stock shortly after. For individuals who are considering these types of transactions, it’s important to understand whether or not these types of transactions will fall under the superficial loss rules in the Income Tax Act (ITA). If the transactions do fall under the superficial loss rules, there are implications regarding the ability to realize the losses on the sale of the shares. Understanding the rules around superficial losses and the stop loss rules associated with them can help you plan to ensure you don’t get stuck without the ability to claim the losses that you had hoped to.
What is a superficial loss?
Superficial losses are defined in Section 54 of the ITA and essentially are losses from particular property that ‘during the period of 30 days before and end 30 days after” the individual or someone affiliated acquires “substituted” or identical property as the property sold. Simply put, if say you sell your Lululemon shares on December 15th and either you or someone affiliated to you purchases Lululemon shares between November 15th (30 days before) to January 14th (30 days after) and either you or the affiliated person still owns (or has the right to acquire) the shares at the end of that period (January 14th), then you would have a superficial loss. Now, there are exceptions, however, this is the basis for determining whether a superficial loss exists. It’s also important to note that superficial loss rules relate to transfers made by individuals only. There are also suspended loss rules, which are similar to the superficial loss rules, that relate to transfers by corporation, partnerships and trusts.
What does affiliated mean?
The term “affiliated” is a complex term in the Income Tax Act used to describe a relationship between certain ‘persons’- whether they are individuals, corporations, trusts or partnerships. Since you could write many pages about the different relationships that would be considered affiliated, please read the following as being not an exhaustive definition of affiliate but an extremely general overview of who an individual would be affiliated with.
An individual would be affiliated with themselves and with their spouse or common law partner. The individual would also be affiliated with a corporation they control or a corporation controlled by their spouse or common law partner. The individual would also be affiliated with a partnership or trust that they are affiliated with.
What this means relating to superficial losses is that if you sell the stock personally, for example, to realize the accrued loss and then have your spouse or the company you control purchase more of the same stock within the 61 day period, discussed above, you would trigger a superficial loss and the rules associated with them.
What is the impact of a superficial loss?
Section 40(2)(g)(i) of the ITA discussed that superficial losses are a type of loss that are deemed to be nil. Essentially, it’s saying that if a loss is considered to be a superficial loss, then there will be a limitation on the ability to claim the loss and it will be treated as nil (or no loss).
For example, let’s say John owned 200 shares of XYZ Corporation, a public company, for $100 per share and he sells 100 shares for $85 or a loss of $15 per share. John or an affiliated person acquires 100 shares of the same stock within the 61 day period mentioned earlier and still owns it at the end of that period, the $1,500 loss (100 shares x $15 loss per share) would be treated as being nil for the current sale. From there the $15 loss per share would be added to the existing cost base of the identical shares that were purchased. For the sake of the example, lets assume John purchased another 100 XYZ Corp. shares two weeks after his sale at a cost $75 per share and still holds them at the end of the 61 day period.
So this is how it would look:
Number of shares
Cost base per share
Balance before new purchase
New shares bought during 61 day period ($75 each)
Superficial loss ($15 x 100 shares)
As you can see the individual who hoped they could use the realized loss to shelter some of their capital gains, will be denied the loss, as it will be deemed to be a superficial loss, and the amount of the loss ($1,500) will increase their original cost basis of their shares until a future sale.
Now, in cases where you or someone affiliated reacquires identical property but either acquires or retains less than the amount sold, the loss denial will be pro-rated and a portion of the loss may be allowed. The calculation basically takes the lessor of a) the number of shares sold b) the number of shares acquired in the 61 day period and c) the number of shares left at the end of the 61 day period and divides it by the number of shares sold and then multiplies it by the loss to come to the denied loss.
Taking the same example above, but let’s assume instead of John purchasing 100 identical shares two weeks after the sale, he purchases 25 shares at $75 per share.
So the denied loss would be calculated as follows:
Lessor of the three amounts:
a) Number of shares sold: 100
b) Number of shares re-acquired in 61 day period: 25
c) Number of shares held at end of 61 day period: 125
John would be denied the loss of $375 (25/100 x $1,500 loss). This loss is added to the cost basis of the 25 shares that were acquired within the 61 day period.
John would be able to claim the remaining $1,125 amount as a loss in the current year to shelter gains, if applicable. ($1,500- $375).
How do I avoid having a denied superficial loss?
To avoid superficial losses it’s important to remember the 61 day rule (30 days before and 30 days after) when you sell stock. If you or someone affiliated to you, such as your spouse, acquires the same security within that period and is still holding it at the end of the 61 day period, you will run into these superficial loss rules.
The superficial loss rules are in place to help prevent taxpayers from realizing losses when there is no real intent to dispose of the property.
Superficial losses and stop loss rules are complex and vary depending on the type of property involved. It’s always recommended that you consult with a tax specialist when dealing in complex areas of income tax.
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The information contained in this article is for general use only and should not be viewed as professional advice. Accounting and tax rules and regulations regularly change and individuals should contact a competent professional to obtain accounting and tax advice based on their specific situation.