The superficial loss rules in the Income Tax Act apply to deny capital losses on the disposition of property, if the taxpayer acquires the same or identical property within a certain time period. Basically, the rules are meant to prevent you from triggering capital losses, which can be used to offset any of your capital gains, and then re-acquiring within a short time the same or identical property that generated the loss.
In particular, the superficial rules can apply where
- you sell a property at a loss,
- you or an “affiliated person” acquires the property or an identical property (“substituted property”) within the period beginning 30 days before the sale and ending 30 days after the sale (“relevant period”), and
- you or an affiliated person owns the substituted property at the end of the relevant period.
An “affiliated person” includes your spouse (or common-law partner). It also includes a corporation that is controlled by you or your spouse, or by an affiliated group of persons that includes you or your spouse. An affiliated person also includes a partnership in which you are a majority-interest partner, or a trust in which you are a majority-interest beneficiary (which can include RRSP or RRIF). Interestingly, an affiliated person does not include your child or other relative.
Where the rule applies, your capital loss is denied and deemed to be zero. However, the loss is not necessarily “lost” forever, because the amount of the loss is added to the cost of the substituted property. As such, if the substituted property is later sold, some or all of the loss may be realized at that time (assuming the superficial loss rules do not apply on the later sale).
You sell 1,000 XCorp common shares on the open market for $50,000 and realize a $10,000 capital loss. Ten days later, your spouse purchases 1,000 XCorp common shares for $50,000. Two months later, your spouse sells the shares for $52,000 and neither you nor your spouse reacquires the shares.
Your $10,000 capital loss is denied because your spouse acquired the substituted property (the XCorp common shares) within the relevant period and owned them at the end of the period. However, the loss is added to your spouse’s cost of the shares, which becomes $60,000. Therefore, on the subsequent sale for $52,000, your spouse realizes a capital loss of $8,000. Effectively, this $8,000 loss reflects your original $10,000 loss, net of the $2,000 gain in the shares that accrued while your spouse owned the shares.
If, instead, your child purchased the shares, you would immediately realize a $10,000 capital loss. On the subsequent sale by your child, there would be a $2,000 capital gain.
If you or the affiliated person acquire only a portion of the property, then a proportionate amount of the loss is denied.
You sell 1,000 XCorp common shares on the open market for $50,000 and realize a $10,000 loss. Ten days later, you purchase 500 XCorp shares for $25,000. Two months later, you sell the 500 shares for $28,000.
One half of your initial capital loss, being $5,000, is denied because you reacquired one-half of your original 1,000 shares within the relevant period and owned them at the end of the period. The other half of your initial loss is allowed.
The $5,000 denied loss is added to your cost of the re-purchased 500 shares, which becomes $30,000. As such, when you later sell those shares for $28,000, you will realize a capital loss of $2,000.
As readers may appreciate, since there is a specific 30-day period under the rule, you can avoid the rule if you (or the affiliated person) reacquires the property after the end of the period. For example, if you wish to trigger some capital losses on shares near the end of a taxation year to offset some of your capital gains, you can sell the shares and re-purchase them 31 days later without worrying about the superficial loss rules. (Of course, the longer you wait, the more chance there is that the price of the share will have gone up in the interim.)
“Identical property” is not fully defined in the Income Tax Act. However, the Act does say that a bond, debenture, bill, note or similar obligation issued by a debtor is identical to another such obligation issued by that debtor if both are identical in respect of all rights, except in respect of the principal amount of the obligation.
Furthermore, the following comments are generally accepted by the Canada Revenue Agency (“CRA”) and most tax experts.
Shares in a corporation are identical if they are of the same class. Shares in two different classes of the same corporation are not considered identical, even if the shares of one class are exchangeable or convertible for shares of the other class.
Shares in two different corporations are not identical even if the corporations are very similar.
Units of mutual funds are identical only if they are units of the same fund.
Corporations, Trusts and Partnerships
The rules discussed above apply to individuals. The rules are a bit different where a corporation, trust or partnership (“transferor”) incurs a superficial loss. Although the loss is denied, the amount of the loss is not added to the cost of the substituted property. Instead, the loss is suspended, and can be claimed by the transferor when neither the transferor nor an affiliated person owns the substituted property (technically, the loss is claimed at the beginning of the first 30-day period throughout which neither the transferor nor an affiliated person owns the substituted property).