Tax Loss Harvesting

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Markets can be volatile and while investment losses are never the goal, they can present opportunities for tax efficient portfolio management. Tax loss harvesting is simply the strategy where you sell investments with capital losses to offset realized capital gains. Consider the following example:

  • Fund A has a realized capital gain of $25,000 ($5,000 tax bill assuming 20% tax rate)

  • Fund B can be sold to realize a $15,000 loss which can be used to offset the $25,000 realized gain, resulting in a total of $10,000 of net capital gains ($2,000 tax bill assuming 20% tax rate)

  • This offset results in $3,000 worth of tax savings vs. if loss was not realized ($5,000 tax bill)

* This hypothetical example is for illustrative use only and a 20% tax rate which varies by filing status and income

Using capital losses to offset realized gains can provide some significant tax benefits. Even if you don’t have any realized capital gains, tax loss harvesting can still provide benefits. The IRS allows you to offset taxable income by $3,000 per year in situations where you may not have any realized capital gains. Not only that, but you are also able to carry net realized losses greater than $3,000 into the future (Capital Loss Carryforward). While you may not have realized gains in the current year, you have stocked away losses that will be able to be used to offset any future capital gains providing tax benefits at that point in time.

Before realizing the potential tax benefits, there are some key considerations investors must be aware of:

  • Tax loss harvesting only provides benefits to taxable investment accounts because you can’t deduct losses from tax-deferred accounts such as a 401(k) or IRA.

  • The wash-sale rule states that if you sell a security with a loss and then buy the same or a “substantially identical” security within 30 days before or after the sale, the loss is typically disallowed. The IRS has not provided a definition of “substantially identical” but for example, you can’t sell Stock A at a loss and buy Stock A the next day.

  • In avoiding the wash sale rule, it is important that investors find alternate securities or funds that can be used to purchase upon the harvesting of a loss. Time in the market is crucial and missing out on 30 days can have damaging effects, so it’s important to have appropriate investment replacements ready.

  • There are certain restrictions on the type of losses that can be used to offset gains. A long-term loss would first be applied to a long-term gain and a short-term loss would be applied to any short-term gains. If either category (long-term or short-term) has a net loss, that net loss can be used to offset net gains of either category. For example, a net short-term loss of $15,000 can offset a net long-term gain of $25,000 reducing total taxable gain down to $10,000.

Taxes should never be the sole decision point in any investment strategy but combining these potential tax benefits along with prudent investment decision making can generate positive after-tax results for investors. While year-end tends to be the time of year where everyone is focused on tax planning, market volatility can be sudden thus it’s important to have a well-constructed tax loss harvesting strategy ready to be implemented throughout any year. For any tax specific advice, please consult your tax professional.