Tax Loss Harvesting to Save on Current and Future Taxes by Brian Fritzsche, CFP®, CFA, CRPC®

As several areas of the market continue to make all-time highs, there might not be many assets in a portfolio that have lost money since being purchased.  However, tax loss harvesting is an important option to be aware of before the need for it arises, as the opportunity to execute the strategy may be fleeting.  Individual company stock holdings may also fluctuate out of line with the general market, allowing for the same usage at varying times.  In this article, we will describe tax loss harvesting and explain why it may be useful, both for your current and future tax returns.

Taxation of Investment Income and Tax Loss Harvesting

In a taxable brokerage account, investors are taxed on the income earned each year.  This income can be made up of interest, dividends, and capital gains from selling an asset.  This contrasts with a retirement account—such as an IRA or a 401(k)—in which an investor can earn income and buy and sell assets without any tax consequence.  Tax loss harvesting focuses on the capital gains portion of a taxable account’s investment income.  Any time an asset is sold for more than its purchase price, the owner is responsible for paying capital gains tax on the amount of profit, known as the realized gain.  If the investment was held for over a year, it is considered a long-term capital gain and is taxed at a lower rate than shorter-term holdings.  If, instead, the investment is sold for less than the purchase price, a capital loss is realized.

Tax loss harvesting is the process of intentionally realizing capital losses in a taxable account in order to use the realized losses for tax benefits now and potentially in the future.  An investor can sell an asset to realize a capital loss and immediately repurchase a similar asset so as not to alter the overall allocation of their investment portfolio.  The main benefit to doing so is to get the realized loss(es) on the books for the current tax year, even if the long-term plan is to continue owning the asset.  The holding period of the investment—long term or short term—only affects the taxation of realized capital gains.

How It Works in Practice

Tax loss harvesting should only be utilized in a taxable brokerage account, as there are no capital gains taxes when selling assets at a profit in a retirement account.  As an example, an investor buys Fund ABC for $20,000.  Six months later, the fund has lost money and is now only worth $12,000.  If Fund ABC is sold and the $12,000 proceeds are used to buy a similar fund, Fund XYZ, the investment characteristics of the portfolio are largely unchanged yet there is now a realized loss of $8,000 for the year.  In a perfect scenario, the two funds would then hold a steady value for 30 days, after which the $12,000 of Fund XYZ is sold (at zero profit or loss) and Fund ABC is repurchased for $12,000.  At that point, the same amount of Fund ABC is owned but with $8,000 of realized capital loss that would not exist if the fund was just held continuously.  Even if the two funds gain in value during the 30-day period, the investor will still be able to realize a capital loss for the year as long as the Fund XYZ holding is worth less than $20,000 when it is sold to repurchase the original Fund ABC.  If both funds continue to decrease in value, the short-term loss in Fund XYZ can also be harvested when Fund ABC is repurchased.

Key to proper usage of this strategy is avoidance of the “wash sale” rule that dictates that realized capital losses cannot be deducted if the same asset is purchased within 30 days of the sale.  This rule is the reason why the investor in our example cannot sell Fund ABC at a loss and simply repurchase it immediately.  The 30-day window goes both directions, so it is also impermissible to buy an equal amount of Fund ABC in advance of selling the original holding at a loss.  In order to keep the portfolio allocation unchanged and avoid having the proceeds out of the market for a month, the replacement fund should be allocated and invested similarly to the original fund.  A similar but acceptable replacement fund could use a different benchmark of the same basket of stocks or have a slightly different allocation methodology.  It is not sufficient to simply use a different fund company’s product if they are both tracking the same index.

Benefits and Risks of Harvesting Losses

There are multiple options for using the realized capital losses generated in a taxable account.  If there are other gains realized in the portfolio that year, the capital losses can be used to offset some of the taxes owed on those profits.  Additionally, up to $3,000 in realized losses can be deducted on a federal income tax return.  The $3,000 deduction can even be used to offset non-investment income such as employment pay.  Any additional realized losses that cannot be deducted now can be carried forward indefinitely, where they may be used to offset realized gains or earned income on future tax returns.

The tax benefits of using this strategy are offset by the risk that the replacement fund does not perform as expected (similarly to the original) during the 30-day replacement holding period.  Going back to our example, if Fund ABC rebounds from $12,000 back to $16,000 while the replacement, Fund XYZ, only increases to $14,000 during the 30 days, the $2,000 difference is lost compared to the investor who held Fund ABC the entire time.  Therefore, selecting replacement funds that act similarly to the original but do not violate the wash sale rule is a critical component of this strategy.  This risk is also the primary reason why it makes sense to wait for a large percentage drop in a certain holding as opposed to trying to harvest losses every time an investment goes into the red.

Final Thoughts

The pandemic-induced stock market drop in early 2020 represented an opportunity for tax loss harvesting in many assets.  While the market rebounded quickly after bottoming on March 23rd, investors that were able to act fast could take advantage of realizing capital losses while also participating in the subsequent rebound using replacement funds that invested in a similar basket of stocks.  Please contact us if you have any questions on how to make the best use of this strategy.

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