‘Tis the tax-loss harvesting season
How losses can make lemonade
As we close out the year, everyone wants to know what they can do to mitigate any tax bite come April. Tax-loss harvesting is one of the most common tactics in wealth management when it comes to taxes.
Unserious side note: Who even had losses this year?! The S&P 500 is up over 15%, international developed markets are up over 25%, and emerging markets are up 28%! What a stellar year for large caps, with international equities finally joining the party. Sorry, small and mid caps, you only gained 5%...
Anyway, let’s get to it! In practice, tax-loss harvesting is the sale of a position with a loss. This realizes the loss, and that loss could be useful!
Of course, we hope that there are no positions with losses, but we like to live in the real world here. Losses over a 1-year time frame are usually inevitable.
When the sale occurs, the capital loss may be used against capital gains! This can allow an individual to avoid the tax bite that comes along with a capital gain. If there are more losses than gains, up to $3,000 can be used against ordinary income each year.
For someone in the 37% bracket, that $3,000 loss is tax savings of $1,110! Pretty significant!
A classic “make lemonade” strategy here. Taking a loss and using it for a current benefit. Losses are no fun at all, but the ability to use them strategically when they occur can be helpful.
Now, let’s get to some caveats.
Most long-term investors are looking for broad-based exposure to the market. Realizing a loss is great, but something called the wash-sale rule can come into play.
To avoid the wash-sale rule, which eliminates the current usefulness of the loss, a replacement fund may not be substantially identical to what was sold. “Substantially identical” is up to interpretation… No further comments from me on this, but I encourage everyone to do their own research or work with a professional to fully understand the implications.
The point here is that realizing a loss that completely throws the target allocation out of line may not be worth it!
Tax-loss harvesting is, at its core, income shifting. An investor is looking to use a realize a loss today, replace that holding with something that is not substantially identical, and continue on their long-term investing path.
Here is a quick example: Fund A was purchased at $10,000.
It currently sits at a loss of $1,000.
The loss is realized, and the proceeds are directed to Fund B, which now has a basis of $9,000 along with a realized loss of $1,000.
So, yes, while a loss was realized today, the new piece of our portfolio now has a lower basis, which, in the event of the fund appreciating and later being liquidated, could net the realized loss to a zero-sum game. This is why some refer to tax-loss harvesting as an “income shifting” tactic.
That isn’t to say loss harvesting isn’t useful, but it can be used strategically in higher income years or when large gains have been realized. This can produce a more meaningful amount of “tax-alpha.”
This is where the idea of tax arbitrage comes into play. Using losses based on an individual’s specific scenario can lead to optimization and tax-alpha.
Here are two examples of when realizing losses can be useful:
Using losses against short-term capital gains
Using losses when in higher long-term capital gains brackets
Here is an example of when realizing losses can be less useful:
Realizing losses within the 0% capital gains bracket. (This is usually when tax-GAIN harvesting is most useful.
Short-term losses net against short-term gains first. Long-term losses against long-term gains. Then, the losses can be used to offset the remainder of gains, no matter the holding period.
After all that, any remaining losses can be used against ordinary income up to $3,000. If there are STILL losses, they can be carried forward to the next year or any year thereafter! (At the federal level, some states do not recognize the loss carry forward.)
December is the typical time to review portfolios for losses as the clock is ticking. The losses must be realized in the tax year to be used against gains or income for that tax year.
For those with significant realized gains, realizing losses can have a significant impact on that tax bite!
But as always, don’t let the tax tail wag the dog. Sometimes we fool ourselves into tax-optimization strategies that really won’t move the meter!
Compounding usually works best when we spend less time tinkering with our portfolios!
PS: This only works in taxable accounts! Any tax-advantaged account cannot benefit from tax-loss harvesting. Although these accounts can still run into wash sale rules when something is sold in a taxable account and repurchased in a tax-advantaged account.
This is for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of publication and are subject to change without notice. Past performance is not indicative of future results.