When we sell an investment for a loss, especially a short-term loss, it can be confusing. Why did we sell an investment we just purchased? Was it a mistake to have purchased it in the first place? These sales are not mistakes; they are clever tax planning.
Tax-loss harvesting is the strategy of realizing significant capital losses in order to save on future tax burdens.
How are realized capital gains or losses taxed?
The capital gain of an asset is the current value of an asset minus its original purchase price (its cost basis). If that value is negative, we call it a capital loss. While you are holding the asset the gain or loss is unrealized and therefore not a taxable event. When you sell the asset you realize the gain or loss.
Realizing capital gains or harvesting capital losses is a taxable event. Capital gains are taxed at their own qualified tax rate based on the level of your non-qualified income. The 2019 qualified rates are 0%, 15%, or 20% and can be potentially increased by the Net Investment Income Tax which is 3.8%.
Throughout the tax year, capital losses offset other capital gains realized, and you are only taxed on net capital gains. This means that by harvesting capital losses, you can immediately save anywhere from 15% to 23.8% of the amount of gains you offset on your federal return. If you experience a state tax rate as well such as Virginia’s 5.75%, those savings are increased. Avoiding up to 29.55% in taxes on a capital gain of any size is a substantial immediate tax savings.
If you harvest more capital losses than capital gains, then you have a net capital loss for the year and can deduct up to $3,000 of that capital loss on your tax return. If you are in the 24% Federal tax bracket and experience Virginia’s 5.75% state tax, deducting $3,000 could be worth 29.75% or $892.50 in immediate tax reduction.
Capital losses in excess of $3,000 are carried forward on Schedule D to use in future years. These banked losses provide the important benefit of being available to pair against realized capital gains or income in future years.
Selling significant losses is not a mistake.
It is not a mistake to have invested in something that goes down. There is a big distinction between unfortunate market movements and a mistake in purchasing something. Short-term market movements can be upsetting but should not shake a well-crafted investment strategy.
Some investors have the philosophy that they will never sell a position for a loss. This philosophy may be appropriate in illiquid assets, but it is not the best strategy for the stock market. The fund has gone down, but there are advantages to realizing the loss.
Rebalancing means taking money from investments that have gone up and investing in categories that have gone down to better align the portfolio with its target allocation. Because of low correlation between the components, there can be a substantial rebalancing bonus which both boosts returns and lowers volatility.
However, taking money from investments that have gone up means selling appreciated stock. If that holding is held in a taxable brokerage account, then those realized capital gains will go on your tax return.
We think the rebalancing bonus justifies realizing some capital gains, but it is even better if we can pair the gains against banked losses.
As advisors, we look at our clients’ accounts frequently and rebalance quarterly. Frequent attention to client accounts means we are able to take advantage of long- and short-term losses for our clients. While we are looking at accounts frequently, we do not immediately sell something that has gone down to bank the loss. We usually wait until the position has lost at least 5% of its value and at least $3,000 before we harvest losses for taxes. Losses of this size are significant enough to provide tax savings and infrequent enough to justify the work required to realize the loss.
One standard deviation of market movements over a month falls within -3.66% to 5.20%. When a position is only slightly down, we might just rebalance by putting a little more in that category instead of realizing every loss. Most months we are not tax-loss harvesting. Occasionally though, one stock category drops by more than 5% and provides tax-loss harvesting opportunities.
For clients who have multiple positions of the same security, one trade lot may have a loss while older trade lots have gains. We optimize tax-loss harvesting by selling short- and long-term losses before selling long- and short-term gains.
Strategically realizing capital losses is valuable.
Capital losses are extremely valuable and yet represent an investment that has lost money. Obviously, no one purchases investments hoping that they will go down in value. However, the markets are inherently volatile. Investments often go down in value, up again, down again, up and down a few more times, and then eventually stay up.
Tax-loss harvesting is the strategy of selling something during one of those down movements to save money on taxes. Unfortunately, if all you do is sell the holding, you might miss the investment’s recovery when it gains value again.
For this reason, in addition to selling the holding for a loss, we usually want to buy something else in order to remain invested in the market category. We invest in positions that we believe have long-term potential for appreciation. While the position may lose value in the short term, we want to remain invested for the long term.
If possible, we would prefer to sell the position and immediately buy back the identical position. But the Internal Revenue Service (IRS) prohibits a taxpayer from claiming a capital loss on their taxes if they buy a substantially identical security within 30 days before or after the sale (called a wash sale).
Once we have sold a position or part of a position to realize the loss, that investment category might be under its target allocation. Remaining fully invested requires some specialized trading techniques. There are several options.
We can purchase a different but similar investment that is in the same general asset class. For example, if we sold shares of the Vanguard Energy ETF (VDE) we could purchase the Vanguard Energy mutual fund (VGELX), bank the losses in VDE, and remain invested in energy by purchasing the alternate fund. These two holdings, while similar, are not substantially identical securities.
Another method would be to sell the energy position, wait 31 days to avoid a wash sale, and then repurchase the same holding. The risk of this strategy is that energy will go up during the month we are sitting on the sideline and when we repurchase energy it is more expensive. It also requires us to either sit in cash for 31 days or find a different short-term investment.
A third method would be to purchase more of the position before selling, effectively doubling up on our target allocation. After waiting 31 days to avoid a wash sale, we can sell the original position for a loss, keeping the second position. The risk of this strategy is that in the time we are doubled up, the position goes down further and we have twice the loss we would have otherwise had. It also requires that we have cash sufficient to double up on our original investment.
If there is more than one category with a capital loss we want to harvest, we can also combine these two strategies. We can sell position A to double up on position B. Then after 31 days, we sell the original position B to purchase position A again. When there are two roughly equal positions with losses, this keeps us from sitting in cash for 31 days or needing to have the cash necessary to double up. The risk of this strategy is that position A may appreciate while we are not invested and position B may drop in value while we are doubled up.
Those who are charitably inclined may avoid paying capital gains tax entirely.
Tax-loss harvesting even has tax benefits for those who are charitably inclined.
Imagine a client has $5,000 cash that they want to give to charity. Instead of giving the cash to charity, we look at their investments for tax savings ideas.
We’ve written before about the benefits of giving appreciated stock to charity. In that strategy, the client would gift $5,000 worth of the appreciated stock to charity and use the $5,000 cash to repurchase the same investment. This keeps the capital gains off their tax return while remaining fully invested and meeting their charitable intentions.
Tax-loss harvesting partners well with this strategy. Harvesting capital losses both adds a capital loss to your tax return for immediate tax savings and also increases the cost basis of the newly purchased holding over the one sold. With an increased cost basis, the holding is more likely to become appreciated stock which you can later gift to charity.
Banking the loss gives us a tax benefit while gifting the stock avoids the future capital gains.
Even if you don’t ultimately give the stock away, you may hold the investment for decades before realizing the gain or you may avoid the tax entirely. If you hold the appreciated stock in your portfolio when you die, your heirs get a step up in cost basis and you avoid paying tax on the appreciation during your lifetime.
While you can only use $3,000 per year of capital losses to reduce your taxable income, you should bank as much capital loss as possible for other future uses.
While no one hopes for the market to go down, having a balanced portfolio generally means having holdings with both losses and gains. Taking advantage of harvesting losses creates a tax-efficient use for the losses that can help keep your portfolio balanced in the future.
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