What is tax loss harvesting?
This is a buzz word that is used very often (too frequently) in the investing community. Tax loss harvesting is the liquidation of investment positions that have unrealized losses strictly for the purpose of offsetting any recognized gains for the year. In human terms, this means that you’ve sold a stock or mutual fund for a taxable gain at some point during the year. You realize that you’ll have to pay tax on that gain if you do nothing, so you decide that you’ll sell one of your positions that has lost money (has unrealized losses) in order to offset the previously recognized gain.
For tax purposes, capital gains and capital losses can offset each other. You are taxed each year on your net capital gains from sales of securities. Tax loss harvesting is most effective when you have any recognized short-term capital gains. Short-term capital gains are gains from sales of securities that you’ve held for less than one year. These are the ones that are taxed as ordinary income, rather than the more favorable capital gains tax rates. If you have short-term gains in your portfolio for the year, selling any losing positions (whether short-term or long-term), can help offset this gain and the corresponding tax burden. This can save a lot of money in taxes if you are in a high marginal tax bracket.
Please note, these strategies are only relevant for taxable investment accounts. In other words, don’t do this in your IRA or 401(k) because those accounts are tax-deferred as it is. Gains and losses are irrelevant for tax purposes in these accounts until you actually pull the money out of it.
Common misconceptions & mistakes
One important thing to note is that tax loss harvesting is really only useful when you have gains in your investment portfolio. Selling bad positions and taking losses is never inherently a good thing. It means that you bought something that decreased in value, and that you think the probability of it increasing in value is low enough to warrant you just getting out of the position all together to save money in taxes. However, let’s say that you purchased a stock that pays a high dividend. You don’t care too much about the market value of the stock because you are mostly looking for the income associated with the dividend payments. Towards the end of the year, the value has decreased in this stock. You know that there are a lot more stocks just like it that pay high dividends, which will help you accomplish your income goals. You decide to get out of this one strictly for the purpose of recognizing the loss, and you can purchase another dividend-paying stock to replace the income you lost by selling it. That’s a pretty legitimate use case for people who use this strategy.
One common mistake that I see is a lack of communication between financial advisors and the guy that actually prepares the taxes (I prepare the taxes). Often times advisors will assume that their gains need to be offset, but the taxpayer may have a capital loss from another investment that is not managed by the advisor. This can lead to large loss carryovers. Remember, only $3,000 in net capital losses can be taken each year. That means that if you have $10,000 in net capital losses in a given tax year, you will deduct $3,000 from your taxable income. The remaining $7,000 will be carried forward until you have net capital gains to use against it. This is not necessarily the worst thing in the world, but it could mean that an advisor could have maintained a position in a security that may have made more sense for your portfolio.
Wash sale rules
One of the most common mistakes is a lack of knowledge about the wash-sale rule. Some taxpayers are holding a stock that they’ve lost money on all year. On December 31st, they decide to sell it and take the loss for tax purposes. However, they still want to be invested in that security, so they purchase it again on January 5th. The IRS has wash-sale rules in place that prevent taxpayers from doing this. They’ll disallow the loss because you entered the same position within 60 days of the sale of the stock. If you’re going to do any sort of tax loss harvesting, you have to make sure you purchase a new position that is not substantially the same as the one you sold.
Those are pretty much the basics. If you have specific questions about this strategy, feel free to reach out to me about the tax aspects of it. For all investment advice, you should talk with your financial advisor.