Breaking the Code: Tax-Loss Harvesting
By: Antony T. Khalife, CPA, MST, CFP®
As year-end approaches, one strategy clients should utilize, in conjunction with their investment advisor, is tax-loss harvesting. What is tax-loss harvesting? It is the practice of purposefully selling securities (stocks, bonds, mutual funds, or other investments) that have lost value which triggers the recognition of a capital loss. By realizing those losses, you may offset capital gain income recognized during the year or even ordinary income. Note that there are some areas of caution that also come along with this strategy, which we’ll dive into.
Picking the “Losers”
As of mid-November, the S&P 500 was up about 24% year-to-date. With such a strong market performance, what investments could have lost value? As with any well-diversified portfolio, there will always be securities that have appreciated in value along with others that have depreciated. The key to an effective strategy is to evaluate your current portfolio and specific holdings – consider the following questions: What do you own? Why do you own it? Does it generate income? Are you expecting future gains/appreciation? How does this security fit in with your investment strategy? Is my portfolio diversified? There are a variety of reasons to buy and sell securities that you should keep in mind while also considering your long-term goals and objectives.
Wash-Sale Rules
Now that you have identified the securities with losses, you will want to sell those securities and reinvest the funds. Before you do so, you should be aware of the “wash-sale” rules to ensure the losses you generate are not disallowed. If you sell a security for a loss, there is a 30-day window (before AND after the sale) in which you cannot purchase the same security or a “substantially identical” security. This rule exists to discourage the sale to simply claim a tax loss. If you hold individual stocks, this is relatively straightforward – just do not repurchase the same security. If you like a particular industry or sector, you may reinvest in a similar company (for example – Microsoft vs Apple). This becomes a little more complicated with mutual funds or ETFs. If you repurchase the same security or a “substantially identical” security within the 30-day window, any loss generated will be disallowed as if the sale did not occur in the first place.
What income can I offset with my capital losses?
If you are able to successfully sell securities and realize a capital loss, what income do these losses offset? If you are in a net capital gain position, the losses will offset any other existing capital gains, regardless if the gains are long-term or short-term (same applies to the loss). For example, you have $10,000 of long-term capital gains and realize $4,000 of short-term losses – the net result is $6,000 of long-term gains. The reverse is also true. If the total losses generated exceed your capital gains, you may utilize up to $3,000 of these losses against other/ordinary income. For example, if you have a net capital loss of $7,000 and have W-2 wages of $200,000, up to $3,000 of capital losses will offset your W-2 wage income. The remaining $4,000 of capital loss will carryforward to the next tax year to offset capital gains or ordinary income next year.
Overall, there are a number of reasons to consider tax-loss harvesting. If you have significant capital gains recognized in 2019, you may want to realize losses to offset those gains. If you are trying to rebalance your portfolio with a net zero tax impact, you could identify losses and gains that offset. This strategy should only be employed in any non-qualified investment accounts (after-tax accounts) – harvesting losses in any IRA, 401(k), or other qualified account has no tax benefit. However, you should keep these accounts in mind while reviewing your overall portfolio and diversification as they are all part of your complete financial picture.
To ensure compliance with the requirements imposed on us by IRS Circular 230, we inform you that any tax advice contained in this communication (including any attachments) is not intended to and cannot be used for the purpose of: (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.