Ever heard someone say an investment loss may be beneficial? Sounds counter-intuitive, right? Interestingly enough, there are situations in which an investment loss may be beneficial for your situation. Benefitting from investment losses involves taking advantage of a strategy known as tax-loss harvesting.
The U.S. tax code allows an individual to offset capital gains with capital losses through sales of investments that have decreased in value – in other words, by “harvesting” investment losses. Using a tax-loss harvesting strategy can potentially reduce your tax liability.
Turning Lemons Into Lemonade
Tax-loss harvesting is a way an investor can turn some lemons into lemonade. Few investors are right 100% of the time, especially when it comes to choosing stocks — we all end up with a couple of “lemons” in our portfolio from time to time.
Suppose you hold a stock in your portfolio that has increased significantly in value since you first purchased the stock. You then decide that you want to sell this stock and realize the gain. If you do sell and decide to realize that gain, you may have to pay capital gains tax on those realized gains during the tax year in which you sell the stock.
However, you notice another stock in your portfolio has decreased in value. With tax-loss harvesting, you would sell this stock and book the loss. You could then reduce your taxable gain in the other stock by some or all of this loss.
If capital losses exceed capital gains, the excess can be used to offset other income, like wages, up to a $3,000 cap. When a net capital loss exceeds the $3,000 limit, it can be carried forward to future years.
In the following years, the loss carried forward would first be used to offset potential capital gains. If capital losses still exceed capital gains, you can claim up to $3,000 as a loss and continue doing so year over year until the net loss amount is reduced to zero.
If you happen to be in the 28% tax bracket, a $3,000 loss could result in a tax savings of about $840!
Use Tax-Loss Harvesting to Take Advantage of Market Corrections
Intra-year stock market corrections are rather common. In the last 17 calendar years, the S&P 500 has seen a decline of at least 10 percent in 12 of those years. Investors may be able to use these market declines as an opportunity to harvest losses.
The main risk to this strategy is the opportunity cost of being out of the market. Many intra-year corrections see a subsequent market bounce. You want to avoid the possibility of being out the market to realize a loss and miss significant market gains. The “wash-sale” rule, which we will review next, further complicates this matter.
The Devil is in the Details
There are a few details to be aware of before adopting a tax-loss harvesting strategy. The first important detail is the “wash-sale rule." This IRS rule prohibits you from selling an investment at a loss, and within 30 days before or after this sale, buying a “substantially identical” stock or security. Doing this would represent an obvious attempt to dodge taxes by manipulating the tax code.
You want to avoid selling positions to realize a loss and waiting 30 days in cash for the wash-sale time period to expire. To proactively find this type of tax-loss harvesting opportunity, you need to have a strategy to keep market exposure. This could be as simple as selling a U.S. large cap stock and purchasing a broad market index to keep market exposure and avoid being in cash during a market run-up.
Consider the following example, say you had a loss in a technology stock, you could conceivably sell the position (realize the loss) and purchase a technology sector exchange-traded fund (ETF) to maintain some exposure to the position for 30 days at which point you could sell the ETF and re-purchase the stock. Be aware this could result in a short-term gain if the “placeholder” investment has a gain in the 30 days it is held.
The second important detail relates to the strategy of tax-loss harvesting itself, which goes against the traditional investing strategy of “buy low, sell high.” Once you sell an investment at a loss, you’ve locked in that loss — you will never have the opportunity to recoup the loss and potentially realize a gain in that security. So if you believe that a stock you own is still a sound investment, even if it’s currently worth less than you paid for it, you might be better off holding onto it.
On a cautionary note, it is a good idea to avoid letting the tax tail wag the dog. Sure, saving money and paying less in taxes is great, but it is generally ill-advised to base investment decisions solely on tax considerations. More importantly, determine whether or not a particular buy or sell decision fits into your overall investing plan.
Timing of Tax-Loss Harvesting
Tax-loss harvesting can be practiced at any time of the year; however, it’s often done near the end of the calendar year, when investors are looking for ways to reduce their tax bill for the year. Additionally, tax-loss harvesting can play a role in portfolio rebalancing efforts. This is when investors attempt to bring their asset allocation back in line after market moves have knocked their portfolio out of balance.
Obviously, engaging a tax-loss harvesting strategy requires you to have tax losses you can realize in the first place. Typically, when the stock market sees a significant drop – like the drops that occurred during the great recession and again in 2015 – is a good time to entertain the possibility of using a tax-loss harvesting strategy.
An Objective Viewpoint and Analysis
ACG can help you determine if tax-loss harvesting is a sound investment and tax strategy for you. We will look at your situation from an objective, unemotional point of view — which may sometimes be difficult for investors since the strategy requires booking investment losses. To learn more about tax-loss harvesting, please give us a call.