There are two things on many investors’ minds at the moment: the looming tax deadline, and the current state of the stock market. Neither can be avoided. (I sometimes wonder if the old saying should be revised to, “Nothing is certain except for death, taxes… and market volatility.”) Fortunately, there is a strategy that can help turn today’s temporary stock losses into future gains. Called tax-loss harvesting, this approach can be used to minimize what you pay in capital gains taxes by offsetting investment gains with investment losses.
Tax-loss harvesting in action
At the most basic level, tax-loss harvesting is the practice of selling a security that has experienced a loss to offset gains from other positions. Once the security is sold—or ‘harvested’—it is replaced by a new investment to maintain the portfolio’s preferred asset allocation. Harvesting losses on investments makes it possible for investors to offset gains, reduce ordinary taxable income by up to $3,000 per year, and often increase after-tax returns. Here’s an example of how the process works:
It is near the end of the calendar year, and Janet’s investment account has realized gains of $3,000 upon which she will owe capital gains tax. Janet currently holds American Airlines stock which has an unrealized loss of $5,000.
She can sell her position in American Airlines, replacing it with another airline stock, Southwest Airlines, keeping her exposure to the transportation sector which she believes will be profitable. By realizing the $5,000 of loss in American Airlines, Janet has fully eliminated her capital gains for the year (mentioned earlier, $3,000), and additionally allowed herself to offset $2,000 of ordinary income from her job as a consultant.
After holding Southwest Airlines for 31 days, Janet has the option to swap back into her original position in American Airlines. Of course, she should first consider whether Southwest made money, and the tax implications from selling that position with a potential short-term gain.
As you might expect, there are a few caveats that make tax-loss harvesting a bit challenging. Otherwise, why wouldn’t a savvy investor sell all of their loss positions and immediately repurchase them? The IRS generally avoids offering a reduction in tax liability without a catch; enter the Wash-Sale Rule. The Wash-Sale Rule disallows the immediate repurchase of the sold investment (or a “substantially similar” investment) within 30 days of selling. The Wash-Sale Rule is enforced using the information reported on Schedule D of your tax return.
Tax-loss harvesting also has its limits. The IRS caps the benefits of tax-loss harvesting at $3,000 for the purpose of reducing your taxable income ($1,500 each if married filing separately) in a single tax year. In our example above, Janet reduced her ordinary income tax by $2,000! The IRS does, however, allow you to carry additional tax losses forward on future tax returns. However, there is no limit to the amount of capital gains you can reduce using tax-loss harvesting. Example, if you have $100,000 in capital gains in a given year, you can fully offset the entire amount if by selling positions which had $100,000 in unrealized loss.
Is tax-loss harvesting always a good move?
While tax-loss harvesting almost always looks good in theory, there are several factors that can limit the benefits of the strategy. Changing market environments, suitable replacement investments, and current and future tax rates can all impact the effectiveness of the approach. Investors in higher tax brackets will benefit the most from tax-loss harvesting. And, as is often the case, whether the strategy makes sense for you depends on your unique financial profile, including the structure of your portfolio, your time horizon and personal goals, and your current and expected tax situation.
For these reasons, it is important to look beyond the short-term tax implications and carefully weigh the benefits against the risks—ideally with the help of a professional who understands the complexities of tax-loss harvesting and how it can impact your long-term wealth. At Leisure Capital, our investment committee combines over 100 years of investment experience, and fully half of the investment committee holds the Chartered Financial Analyst (CFA) designation, which helps build a fundamental understanding of investment management concepts such as tax-loss harvesting.
At Leisure Capital Management, we do not prepare taxes for our clients; our team is focused 100% on investment management and charitable and gift planning. However, helping to mitigate taxes and retain and preserve our clients’ assets is one of the most important services we provide—including applying tax-planning strategies like tax-loss harvesting. If you would like to discuss if tax-loss harvesting is appropriate for you, please give us a call. We are always at your service!
This article is not intended to constitute tax advice. Tax-Loss Harvesting can quickly become complicated, and this article intends to cover the topic broadly as to communicate its general use and impact. Please consult your tax professional before attempting to lower your capital gains tax liability.