Positive investment performance is desirable, but not achievable 100% of the time.Though it may seem counter-intuitive, the upside to negative performance in an investment is the potential tax savings when the investment is sold or distributed.
There are times, during both good and bad market years, when seeking to generate losses through the sale of under-performing investments may present an opportunity.
Reaping the Benefits of Losses with Tax Loss Harvesting
The U.S. federal tax system allows for taking realized capital losses on investments against income, which reduces a taxpayer's overall income tax liability. The process of tax loss harvesting involves proactively selling investments in taxable, non-retirement accounts where the current market values are below the purchase cost bases. This enables the investor to realize losses, which can then be used to offset realized gains as well as additional income.
How Can You Apply Tax Loss Harvesting to Your Financial Situation?
Tax loss harvesting can be effected with stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Beyond offsetting capital gains…
Any net losses (losses that exceed gains) can be used to offset $3,000 in ordinary income.
Net losses on marketable investments can also offset gains on the sale of assets, which are taxed at higher long-term rates like gold coins or a gold ETF (at 28%), or depreciation recapture on rental property (at 25%).
Any net losses not used to offset gains or ordinary income in one year may be carried forward indefinitely to offset realized gains in other years.
Depending on portfolio investments and selling strategy, long-term losses could be used to offset short-term gains which are taxed at ordinary income tax rates.
Also, you can sell an asset class- like internationals-- and immediately buy the asset class back with a different fund. This strategy allows you to maintain the same allocation to an asset class with a slightly different fund, while reaping the tax benefit.
Let’s walk through an example to demonstrate how tax loss harvesting works...
Mary owns two investments- BLUE stock and RED stock. BLUE has a $100,000 accrued gain in the investment and RED has a $50,000 loss from its cost basis. Mary is in a tax bracket such that if she sold BLUE stock she would pay 23.8% tax (20% capital gain plus 3.8% net investment tax) on her gain, generating a tax liability of $23,800.
$100,000 BLUE Gain @ 23.8% = $23,800
However, if Mary sold both her BLUE and RED investments, she would reduce her taxable gain to $50,000 and her tax liability to $11,900.
$100,000 BLUE gain (minus) $50,000 RED loss @ 23.8% = $11,900
Why Would Mary Want to Take a Tax Loss on Her Under-performing RED Stock?
Taking the loss on RED could be a choice that is investment strategic. Perhaps, a determination that RED stock was not going to render positive performance in the foreseeable future supports a conclusion that it would be a good time for Mary to sell RED. Or, perhaps, Mary has several lots in RED stock, some of which are at a gain, but she decided to sell her highest purchase cost basis lot because it proffers the best opportunity to take a loss which she can use for reducing her tax liability on her BLUE gain. This approach would exemplify a HIFO (highest-in-first-out) strategy.
Why is 2018 a Particularly Good Time to Pursue a Tax Loss Harvesting Strategy?
Even though tax loss harvesting presents a tax savings opportunity in both good and bad market years, the 2018 market volatility may enable investors to lock in greater gains and net those gains with losses to minimize their tax liability. The type of volatility we are experiencing creates considerable divergence – of different international markets, of different industry sectors, and of different asset types, and fielding a net of gains and losses in this environment can be the most effective when compared to less volatile market environments.
This divergence can also create a need for rebalancing an investment portfolio necessitating transactions to bring the portfolio into parity with its objectives. Prospective performance can also drive the need for trading. For example, interest rates and their effect on medium-term and long-term fixed income investments may prompt a transfer to shorter-term investments. In short, the opportunity to generate a loss for tax purposes may be attractive outcome coupled with a need to properly maintain the portfolio.
What are the Risks Associated With Tax Loss Harvesting?
One considerable risk when harvesting losses is the wash sale rule. The IRS prohibits the recognition of a loss for tax purposes if “substantially identical” securities are purchased within 30 days before or after the loss generating transaction.
What qualifies as a “substantially identical” security?
Securities are the same stock
Two different classes of stock issued by the same corporation
ETFs offered by different investment firms that track the same index
A loss could be excluded, in whole or part, if the wash rules are not followed. Note that inadvertent violation of the rules can occur if a dividend reimbursement election is in place on a particular security and a reinvestment takes place within 30 days of the loss transaction.
There are many reasons and potential applications for investors to employ tax loss harvesting. You should seek the counsel of your tax advisor and financial advisor when implementing a loss harvest in order to maximize the benefits of this strategy. Throughout the month of December, we will be implementing tax loss harvesting strategies for our clients and will proactively notify those concerned. If you have any questions, please contact a member of the Willis Johnson & Associates team for more information.