Tax-Loss Harvesting: What You Should Know

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Unpredictable, unavoidable, sometimes unforgiving - market volatility can sometimes play cruel tricks on your investments and test the tenacity of even the most seasoned investors. But what if we told you there’s a way for you to leverage the losses you incur on your underperforming investments?

Well, there is. If you want to enjoy the profits from your high-performing investments while being able to capitalize on the losses from some of your failed ones, tax-loss harvesting is a strategy you can employ. By strategically managing your gains and losses, you can minimize your tax burden and optimize your long-term wealth accumulation.

Read on to know more about tax-loss harvesting, what it entails, what its limitations are, and whether you would likely benefit from undertaking it.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is a strategy investors employ to reduce the amount of tax they are liable to pay on the sale of their profitable investments (i.e., on the capital gains they earn), thereby reducing their overall tax liability. These investments could be any tradable security, including bonds, stocks, etc. This method can also be used to offset the taxes a person is liable to pay on their income.

As per this method, an investor sells some of their underperforming investments, that is, investments whose value has fallen below the purchase price (cost basis), and thereby deliberately incurs a loss, which in turn helps decrease their overall taxable capital gains.

How does this work? The investor offsets the capital losses against the capital gains (i.e., subtracts how much is lost from how much is gained).

Before we go any deeper into tax-loss harvesting rules, it’s important that we understand how capital gains work and how they are taxed.

What Are Capital Gains and Losses?

When you sell a capital asset*, depending on the price you paid to purchase it and the price you sell it for, the sale could generate capital gains or lead you to incur capital losses.

Capital gains, therefore, arise from the increase in the value of a capital asset at the time of its sale. In simple terms, you earn capital gains when you sell an asset for a higher price than you purchased it for.

Similarly, a capital loss refers to the decline in a capital asset’s value. This loss is incurred when the asset is sold for a price lower than its original purchase price.

*Capital Asset: Capital assets include almost everything you use for “personal and investment purposes”. This includes valuable possessions like homes and vehicles, which you buy for personal use, or investments like properties, stocks, bonds, collectibles, and artwork.

Capital Gains Tax

If through the sale of a capital asset, you realize some capital gains, you will have to pay taxes on those gains. This tax levy is referred to as capital gains tax.

Short-term capital gains tax

If you hold an investment for less than a year before selling it, you will have to pay short-term capital gains tax. The rate for short-term capital gains is the same as your income tax rate determined based on your income bracket and can go up to 37%.

Long-term capital gains tax

If an investor holds onto an investment for a minimum of one year, they will be subject to long-term capital gains tax on the profits earned from the sale of that investment.

For the tax years 2022 and 2023, the long-term capital gains tax rates vary based on a filer's income and can be 0%, 15%, or 20% of the profit generated from an investment.

How Does Tax-Loss Harvesting Work?

As an investor, you know that when it comes to your investments, you win some, you lose some. While you may want to sell a profit-making investment to realize the gains on it without holding it, doing so opens you up to capital gains tax.

As you saw earlier, tax-loss harvesting presents you with the opportunity to leverage loss-making investments to offset these gains.

Selling an Underperforming Investment

Since several considerations go into whether an investor should sell an underperforming asset to harvest their losses, it is strongly advisable to consult with a financial advisor before doing so. Some of these considerations are:

  1. Current tax bracket

Investors in higher tax brackets benefit from tax-loss harvesting more than others. Why? Because the higher your tax bracket, the more money you can save using this technique.

When it comes to investors in lower income brackets, the benefits of tax-loss harvesting may be outweighed by other considerations such as transaction costs incurred on the sale, the imbalancing effect it has on their portfolio, etc.

Also, if you are an investor in a lower income bracket and you’re not liable to pay long-term capital gains tax, it wouldn’t make it sense to undertake this exercise.

  1. Amount of capital gains earned during the year

Tax-loss harvesting proves most beneficial when an investor has considerable capital gains, which could lead to a substantial tax liability. By offsetting these gains utilizing capital losses, the investor can diminish their overall tax obligation.

But even if an investor doesn’t have capital gains to offset using capital losses, these losses can be deducted up to the limit of $3,000 (or 1,500 if married and filing separately) from their income in a year. Any losses over and above that can be carried to the next year to offset future gains.

  1. Investment’s potential

You’ve heard the old adage - time in the market beats timing the market. While you may have to deal with market volatility in the short term, stocks do offer high growth potential in the long term. Therefore, before you decide to sell your investment, you need to ask yourself whether there are significant underlying issues causing its value to decline, in which case, you could consider selling it.

But if no significant changes have occurred to your investment since you first bought it and if you still believe it has potential, you may want to reconsider your decision to sell it; you might be better off holding onto it and letting it grow.

  1. Duration for which the investment was held

As we saw earlier, this is the basis on which capital gains tax is calculated. You would do well to remember that short-term capital gains tax rates are higher than long-term capital gains tax rates. As mentioned, short-term capital gains are taxed at the marginal tax rate, which could be up to 37%. On long-term capital gains, you could pay a maximum of 20% depending on your income.

  1. Type of account

It is important to note that tax-loss harvesting is relevant only to taxable accounts. Since you’re trying to reduce the taxes you owe, it follows that selling investments in accounts that are tax advantaged (like IRAs or 401(k)s, which are not taxed annually or at all, in the case of Roth IRAs, as the contributions are after-tax dollars) would not make sense.

  1. Tax-loss harvesting deadline

All such sales should be undertaken by the end of the calendar year, i.e., by December 31. But ideally, this should be a year-round exercise, because a capital loss that could’ve been harvested earlier may not be available later on.

Offsetting the Losses Against the Gains

The purpose of tax-loss harvesting is minimizing one’s total tax obligations. By selling a depreciated Investment A, an investor can counterbalance the gains from a profitable Investment B, reducing or completely offsetting the capital gains tax liability associated with Investment B. This could enable the investor to achieve substantial tax savings.

Tax-loss harvesting example

Sarah is an investor with an annual income of around $90,000 in the year 2022. She has two investments - Fund A and Fund B. She has held Fund A for 185 days and Fund B for 200 days; therefore, both funds were held for less than one year.

Fund A appreciates in value by $5,000, and Sarah sells it, thereby incurring short-term capital gains tax on $5,000 (her capital gains).

Fund B depreciates in value by $3,000.

Based on Sarah’s income, the income tax rate applicable to Sarah is 24% (because short-term capital gains are taxed at the ordinary income tax rate applicable to a person).

Without tax-loss harvesting, she would have to pay the following in taxes:

0.24 x $5,000 = $1,200

Now, suppose Sarah realizes the capital loss by selling Fund B at a loss of $3,000. This means she can offset (minus) the capital loss of $3,000 from her capital gains of $5,000, thereby bringing her taxable gains to $2,000.

Then, she would have to pay:

0.24 x ($5,000 - $3,000) = $480

Replacing the Sold Investment

Post tax-loss harvesting, investors typically use the proceeds from the sale of their underperforming assets to purchase investments with the potential for growth, helping to recover their losses. Additionally, after an asset is sold at a loss, careful portfolio management through tax-loss harvesting involves replacing that asset with a comparable one to maintain the portfolio's balance and expected risk and return levels.

According to some financial advisory companies, tax-loss harvesting works best when it enables an investor to enjoy tax savings without adversely affecting the primary investment strategy underlying their investment. And if it does, the proceeds are invested in an investment that fits the primary strategy.

However, please note that the IRS imposes a limitation on what type of security you can purchase within 30 days of selling your loss-making investment. You cannot purchase a substantially identical stock or security within 30 days from or before the date of the sale. This rule is called the wash-sale rule.

What Is the Wash-Sale Rule?

The wash-sale rule, implemented by the IRS, aims to prevent taxpayers from claiming a tax deduction for a loss on a security sold in a wash sale.

What is a wash sale? According to this 30-day rule, a wash sale is a sale in which an individual sells a security at a loss and, within a 30-day period before or after the sale, repurchases either the same or a substantially identical stock or security or acquires a contract or option to buy a substantially identical security.

Here are some key aspects of this rule:

  • The wash sale rule is triggered even if the individual’s spouse or a company they own purchases a substantially identical security within the 61-day period (since it is 30 days before or after the date of the sale).
  • The purpose of this rule is to prevent investors from generating an investment loss solely for the purpose of obtaining a tax deduction while practically maintaining their financial position.
  • Once this 61-day period is over, the wash-sale rule no longer applies to such transactions.

What Is a Substantially Identical Security?

Well, the IRS doesn’t outright define what this term means. According to the IRS, when assessing the substantial identity of stocks or securities, one must take the specific details and circumstances of each individual case into account.

One clear-cut instance of buying substantially identical securities is buying shares of the company whose shares you sold to harvest your capital losses.

According to Publication 550, which talks about the tax treatment of investment income and expenses:

  • Stocks or securities issued by one corporation are generally not regarded as substantially identical to those issued by another.
  • Bonds or preferred stock of a corporation are typically not considered substantially identical to the common stock of the same corporation.

However, there are some exceptions:

  • If a company undergoes reorganization, the new stocks and securities it issues may be substantially identical to the old.
  • Also, while a company’s bonds or preferred stock are not usually considered substantially identical to its common stock, there are some exceptions. If these bonds or preferred stock are convertible into common stock of the organization, certain circumstances can make them substantially identical to the common stock:
    • If the preferred stock can be converted into common stock
    • If the preferred stock comes with the same voting rights as the common stock
    • If the preferred stock is subject to the same dividend restrictions
    • If the trading prices of the preferred stock do not differ substantially from the conversion ratio
    • If there are no restrictions on converting the preferred stock into common stock

Given that the meaning of this term is quite ambiguous, you must consult with professionals to determine whether the security you want to invest in is a substantially identical security to the one you sold.

Wash sale example

John invests $20,000 by buying 100 of Company A’s shares in October, 2022. By November, the value of his investment is down to $17,000. He sells these shares on November 5, thereby incurring a capital loss of $3,000. He hopes to adjust these losses against his capital gains for the year.

On December 1, he buys 100 shares of Company A’s shares.

In this scenario, the repurchase of Company A’s shares within the 30-day window triggers a wash sale. Despite selling Company A’s shares at a loss, the wash-sale rule disallows John from claiming the capital loss for tax purposes.

While this loss can't be deducted, it gets added to the cost basis of the repurchased shares. Consequently, this cost basis will be taken to determine any gain or loss in a future transaction.

Limits on the Deduction

In the event your capital losses for the year are higher than your capital gains, you can deduct either a maximum of $3,000 ($1,500 if married filing separately) in net losses from your total annual income or your total net loss shown on line 16 of Schedule D (Form 1040), whichever is lower.

If your net losses exceed $3,000, the IRS rules allow the additional losses to be carried forward into the following tax years but not deducted in the same year.

Key Takeaways

  • Tax-loss harvesting is a strategy that allows investors to offset the losses from underperforming investments against the gains from profitable ones, reducing their tax liability.
  • It involves selling investments that have declined in value (underperforming assets) to deliberately incur losses, which can be used to decrease taxable capital gains.
  • Capital gains are realized when an asset is sold for a higher price than it was purchased, while capital losses are incurred when an asset is sold for a lower price than it was purchased.
  • Short-term capital gains tax applies to investments held for less than a year, while long-term capital gains tax applies to investments held for a year or more.
  • Factors to consider before engaging in tax-loss harvesting include current tax bracket, amount of capital gains earned, investment potential, duration of holding, and the type of account.
  • Tax-loss harvesting is most beneficial for investors in higher tax brackets with considerable capital gains, but it can also be used to offset personal income.
  • Proceeds from selling underperforming assets can be used to purchase similar investments and recover losses while maintaining portfolio balance.
  • The wash-sale rule restricts repurchasing substantially identical securities within 30 days of selling them to prevent artificial loss deductions.
  • If your capital losses exceed your capital gains, the deduction you can claim in net losses is limited to $3,000 per year ($1,500 if married and filing separately), with additional losses carried forward to future tax years.

Harnessing the power of tax-loss harvesting can help investors reduce their tax burdens, and maximize potential savings. However, it is important to approach this strategy with caution and seek professional advice to navigate the rules and considerations involved. With careful planning and informed decision-making, investors can unlock its benefits while mitigating potential risks.