Some readers who trade in securities may be aware of the “superficial loss” rules that apply for income tax purposes. The rules are intended to prevent a taxpayer from selling a property at a loss (say, to use against capital gains you have), in cases where the loss is deemed to be “superficial” because the property or a similar property is re-acquired within a set period of time.
Basically, the rules apply in the following circumstances:
You sell a capital property at a loss, and in the period beginning 30 days before the day of the sale and ending 30 days after the sale, you or an “affiliated person” acquire the same or identical property and own it at the end of that period. The period is therefore a total of 61 days (including the day of the sale).
An “affiliated person” includes your spouse or common-law partner, a corporation that you or your spouse or partner control either together or individually (normally meaning ownership of more than 50% of the voting shares of the corporation), among other persons.
Interestingly, an “affiliated person” does not include your child. Therefore, if your child acquires the property within the 61-day period, the superficial rules do not apply.
When the rules do apply, any capital loss on your initial sale of the property is denied and deemed to be zero. On the positive side, the amount of the denied loss is added to the cost of the other property acquired by you or the affiliated person. As such, the loss is not denied forever, because it will be recognized when you (or the affiliated person) eventually dispose of the property.
You sell 1,000 common shares in XCorp for $12 each (total proceeds $12,000). Your cost of the shares was $22 per share (total cost $22,000). In other words, your total capital loss was $10,000.
Within 30 days after the sale, you re-purchase 1,000 XCorp common shares (“identical shares”) for $13 per share and continue to own them at the end of the 30 days.
Your initial loss of $10 per share or $10,000 in total is denied. However, your cost of each identical share is bumped up by the denied loss per share, so that your new cost of the identical shares becomes $23 per share.
If you later sell the identical shares for, say, $13 per share, you will have a capital loss of $10 per share. Half of that, or $5 per share, or $5,000 in total, will be an allowable capital loss, which can be applied against any of your taxable capital gains.
Meaning of “identical property”
As noted, the superficial loss rules can apply if you or the affiliated person acquires an “identical property” within the set 61-day time period.
In terms of shares in corporations, identical properties include shares of the same class of the same corporation. But they do not include shares in different classes. For example, if you sell common shares in XCorp at a loss and purchase preferred shares of a different class in XCorp, the two types of shares are not identical and the superficial loss rules do not apply.
A similar rule applies to units in mutual funds. Generally, in order to be identical, the units must be in the same fund and of the same class.
In terms of debt instruments such as bonds or debentures, they are deemed to be identical if they are issued by the same debtor, provided they are identical in respect of all rights attaching to the instruments, but without regard to the principal amount of the instruments.
Using the rules to shift losses to spouse or common-law partner
Although the superficial loss rules are generally detrimental in nature, they can be used in certain tax planning scenarios.
For example, say you own publicly-listed shares with an accrued capital loss. However, you have no capital gains so you cannot currently utilize the capital loss.
However, your spouse has some capital gains, and could use some capital losses to offset those gains.
In such case, you could sell the shares at a loss. Your spouse could purchase identical shares, and the amount of your denied loss would be added to your spouse’s cost of the identical shares. Assuming your spouse later sold them when they were trading for less than your spouse’s (bumped-up) cost, he or she can use the loss.
Let’s use the same example as above, except that your spouse purchases the identical shares within the 61-day period and owns them at the end of that period.
Your initial $10,000 loss is still denied. However, your spouse’s cost of each identical share is bumped up by the denied loss per share, so that their new cost of the identical shares becomes $23 per share. If they later sell the shares at, say $13 per share, they will have a capital loss of $10 per share, an allowable capital loss of $5 per share, and a total allowable capital loss of $5,000.