Should You Sell Investments At A Loss To Pay Off Debt?

First, I want to acknowledge the risks of investing money you need over a short time horizon into stocks. This is not a criticism, Ruth, as much as it is a lesson for others.

The S&P 500 has had positive annual returns about three quarters of the time over the past 100 years. That means there is a decent chance you may invest money in stocks and earn a positive return over a one-year period. But there is also a one in four chance the investments decline.

If you invest in a couple of stocks as opposed to a diversified portfolio, there is an even higher chance of losing money.

2022 was also a good example of how even “safe” investments can lose money. A typical Canadian bond exchange-traded fund (ETF) or mutual fund that tracked the FTSE Canada Universe Bond Index last year would have lost about 12%. Bonds got hammered because interest rates went up and there is an inverse relationship between rates and bond market prices.

How well do your investments need to perform?

Regardless of how you got where you are, Ruth, the key question is, what should you do now? The ETFs you bought are down in value and your interest rate on your line of credit is way up. You are probably paying 7.2% to 7.7% interest on your line of credit (prime plus 0.5% to 1%).

In order to pay your assumed interest rate of 7.2% to 7.7%, you probably need to earn nearly 9% on your ETFs. The math works like this. If your ETFs earn 9%, you will have to pay tax on the dividend and interest portion, which may be 2% to 3% of the return. That will reduce your return by 1% to 1.5% after tax. Because the values have declined, you will not have capital gains tax to pay on the appreciation until you recoup your losses.

Over the next couple years, might you earn 9% per year on the ETFs? Maybe. Will the interest rate for your line of credit rise, causing the threshold you need to earn to be higher, or will it fall, meaning a lower investment return threshold to come out ahead? That’s difficult to say.

Your decision may only be a compelling one if either stocks or interest rates go way up or way down. In a middle-of-the-road scenario, Ruth, the choice you make may be much less compelling. So, consider this as you contemplate your stress level with the current arrangement.

When should you consider selling?

One thing I would discourage you from doing is using the original investment amount as the number to get back to before you consider selling. It can be detrimental to fixate on recouping a loss before you sell an investment. It may be more empowering to look at it from another perspective.

You could sell those ETFs with the push of a button and turn them into cash. It may cost you $20 or less in commissions at a discount brokerage, Ruth. If you had that same amount of money in cash, would you buy those same ETFs today—which, we agree, you could do instantly and easily? If yes, perhaps you stay invested. If no, consider selling.

If your plan is to stay invested and wait it out, know that it may be a matter of months, or it could take a few years, depending on the ETFs you own and how markets perform.

Watch for tax deductions and superficial losses

You could consider selling the ETFs and paying off the line of credit and then borrowing the money back to reinvest. The reason is the interest will become tax deductible. Right now, the interest is not tax deductible because you borrowed the money to give to your son (for personal use). If you borrow the money to invest in ETFs (for investment purposes), the interest will be tax deductible to you. The after-tax cost of the interest may be cut in half due to tax savings on the deductions.

One word of caution is that if you sell your ETFs at a loss and repurchase the identical ETFs within 30 days, you cannot claim the capital loss on your tax return. Instead, it is a superficial loss as if you never sold the investment in the first place. This may not matter if you have no other capital gains to offset in the current year or the three previous years.

If you did want to claim the capital loss for the current year or carry it back to a previous year, consider selling the ETFs and repurchasing similar ETFs. This could be accomplished by selling an ETF and buying an ETF that tracks a similar index from another ETF provider.

If you decide to hold off until the ETFs recover, Ruth, just remember that this could take a few years. Hopefully it won’t, but stocks can be volatile and risky over a short time horizon. Over the long run, they are a great way to build and maintain wealth for people who do not have any immediate needs for the money or who only need to make small withdrawals. When an investor plans to withdraw most or all of an investment over a time horizon of five years or less, there is always a risk they may be selling at a loss.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.