Tax loss harvesting can help investors improve their overall net returns. It can do this by capitalizing on the differences between tax rates, reducing taxes at higher rates now in exchange for tax at lower rates later. That is, if it’s done correctly.
What Is Tax Loss Harvesting?
Investors harvest tax losses by purposefully selling an investment at a loss to offset taxable gains on another sale, or to offset a limited amount of ordinary income.
Investors can take up to $3,000 of capital losses each year against ordinary income. This is restricted to $1,500 per year for investors filing under the status of married filing separately.
This applies only to taxable accounts; there’s no tax loss harvesting opportunity within tax deferred or qualified plans.
Typical scenarios are for investors who have some short-term capital gains that they can offset with losses on another asset. By selling the other asset at a loss, they can generate a corresponding loss to offset the otherwise taxable gain. Additionally, they can take up to $3,000 of loss against ordinary income.
Wash Sale Rules
Investors need to be careful to avoid wash sale rules. A wash sale is when you sell an asset at a loss and replace that asset with the same or “substantially identical” asset within 30 days (before or after) the sale.
The Internal Revenue Service (IRS) does not allow you to take the deduction for a loss on a wash sale. They will happily let you take a taxable gain, but not a loss.
Most investors go to extremes to avoid the appearance of purchasing a substantially identical asset to replace the asset they are selling at a loss. Extremes are not necessary. You can’t purchase the same fund in a different share class of anything that is really the same.
But you can certainly stay within the same asset class for your asset allocation without being in danger of violating the wash sale rules.
For investors following an asset allocation model, tax loss harvesting in conjunction with rebalancing can solve the problem of avoiding wash sale rules while adhering to their portfolio structure.
Tax Rate Arbitrage
Long-term capital gains rates are favorable tax rates. For the average income earner in America, many of their long-term gains will be taxed at a rate of zero. It is hard to argue that as not favorable. Short-term gains do not enjoy this favorable treatment. This is why investors tend to seek losses to offset short-term gains; they are the ones that hurt at tax time.
When the IRS giveth, the IRS also taketh.
When you take a loss now and replace the asset with another asset, you will have correspondingly lowered your cost basis in the new investment. This means that you will have a greater gain to report at a later date. Let’s look at a quick example to be sure this is clear.
Let’s say you invest $10,000 in XYZ company. You invested from cash, you have a cost basis of $10,000; you will ultimately pay gain only on the increase above your basis.
But the investment starts off in the wrong direction due to broader market circumstances. You sell your shares in XYZ at $8,000, generating a loss of $2,000 for your tax purposes. You reinvest your $8,000 into PDQ company, which is another investment you like, and is not substantially identical.
But your shares in PDQ have a cost basis of $8,000 — not the $10,000 basis you had before. Ultimately when you sell your PDQ you will have this $2,000 difference as an additional gain later.
Your “win” with tax loss harvesting is that you are avoiding tax in the present at your highest marginal tax rate for ordinary income, and paying the tax later — perhaps many years later — at a lower and potentially zero long-term capital gains rate.
Carrying Forward Losses
You are limited to $3,000 per year in losses you can use to offset ordinary income. But you can carry losses forward indefinitely, using them to offset future gains and up to $3,000 each year in ordinary income.
The IRS has no limit on time; you can continue to carry the losses forward. A couple of states have restrictions for state tax purposes, but not the IRS.
Investors tend to think of tax loss harvesting as an end-of-year thing. Investors do this because this is when they are thinking the most about taxes.
There is no reason to limit yourself to end-of-year transactions.
If you have a loss you can capitalize on, you should feel free to do so at any point during the year. You will only be able to use it when you do your taxes, but there is no reason to let a good opportunity slip away because it’s not December yet. If tax loss harvesting makes sense for you, then you should take advantage of the opportunity when it presents itself.
For many investors trading comes with a cost. You have to be careful that what you are gaining is worth the cost of getting it. Tax loss harvesting will typically involve both the sale of the asset to generate the loss and the purchase of its replacement — you’ll have two transactions to pay for. It may not make sense if it’s a very small loss.
You need to understand your rates.
If you have variable income, as many self-employed individuals do, you’ll want to have a good idea of what your year looks like before you go taking losses you can’t use. The gain comes from trading a high rate now for a lower rate in the future. If you have little or no tax liability now, you can’t win on this arbitrage.
The Bottom Line on Tax Loss Harvesting
Tax loss harvesting isn’t for everyone. But it can be used by many people who either aren’t aware of it or think it is too complex for their situation.
It is really quite straightforward. If you have an unrealized loss within a taxable portfolio, you may have the opportunity to recognize that loss and save some money on taxes now, while potentially incurring a smaller, or even zero, liability at a much later date.
And that’s a harvest worth reaping.