2020 will be a year we will remember forever. This year we are experiencing a global pandemic that has exacted a human toll unlike anything any of us have ever seen before. Alongside the human tragedy, we have seen the global economy take a hit as well. Early in the pandemic, we saw sharp declines in the market, which led to opportunities for tax loss harvesting.
What, you may ask, is tax loss harvesting? Tax loss harvesting is a strategy an investor can use to minimize any taxes they may owe on capital gains or their regular income. The strategy involves selling an investment at a loss and replacing it with a similar investment. The resulting realized loss is used to offset any realized gains taken during the tax year. If the investor has not taken any realized gains during the year, the realized loss can also offset $3,000 of income ($1500 if married and filing separately) in one year. Unused losses can be carried forward to subsequent years. One thing to note is that this strategy only applies to taxable accounts. Retirement accounts such as Roth IRAs, IRAs, and 401(k)s are not subject to capital gains taxes.
1. Without tax-loss harvesting:
Gain from sale of Fund A = $10,000
Tax owed = $1,500
(Based on long-term capital gain at 15% capital gains tax rate)
2. With tax-loss harvesting:
Gain from sale of Fund A = $10,000
Loss from sale of Fund B = $10,000
Tax owed = $0
Tax savings = $1,500
You may be wondering why the approach involves selling a security and purchasing a similar one. Why not buy back the same security? Well, the IRS has put quite a few rules/limits in place with regards to this tax loss harvesting strategy. For one, you cannot realize a loss against the capital gain of the same security during a certain time period. To do so is known as a “wash sale.” The wash-sale rule states that within 30 days before or after the sale, an investor cannot sell a security at a loss and buy the same security or one “substantially identical.” A good example of a wash sale is selling Fund A in a taxable account, realizing a loss, and re-buying Fund A within the same account or another account owned by the same person or spouse. Even if the account is a retirement account like an IRA, the IRS will disallow the tax write-off. The best way to avoid a wash sale is to replace the security with an exchanged-trade fund (ETF) that is within the same asset class. Doing so will allow the portfolio to maintain its asset allocation. If you end up being affected by the wash-sale rule, even though the loss is disallowed, the amount of the loss is added to the cost basis of the securities you repurchased, so essentially you do get a benefit, but only when you sell those securities at a later date.
Another limit is that losses are first used to offset capital gains of the same type. There are two types of capital gains and losses: short-term and long-term. Short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can be deducted against the other kind of gain. This distinction is important, especially if you have more gains than losses, because long-term capital gains tax rates are lower than ordinary income rates. If you sell a security that you’ve held for one year or less, the gain will be taxed at your marginal ordinary income tax rate.
If you have $20,000 of long-term losses and only $10,000 of long-term gains, the net $10,000 long-term loss can be deducted against a $10,000 net short-term gain. If your ordinary income tax rate is 37%, you would pay $0 in taxes instead of $3,700.
Tax loss harvesting may also help portfolio returns. By offsetting realized investment gains with losses, less money goes to pay taxes and more stays invested in the portfolio, working for the investor.
When can tax-loss harvesting opportunities be identified? When markets take a downturn, they may provide opportunities to harvest losses. Also, during portfolio rebalancing, lagging investments could be ripe for potential harvesting. In conjunction with tax-loss harvesting, the portfolio can be adjusted back to its originally targeted allocation. Selling assets that have drifted above the target and buying into the underweighted asset classes is essentially following the mantra of buying low and selling high. Portfolio rebalancing and tax loss harvesting at the same time helps you maintain your asset allocation with the added benefit of saving on your taxes.
As always, your Bluerock team is delighted to answer any questions you may have.