As the end of the year arrives, it’s only natural that investors’ thoughts should turn towards holiday shopping, New Year’s resolutions, and tax loss harvesting.
It’s not uncommon for stock investors to wind down the calendar year with capital gains realized in a taxable account earlier in the year, or holding shares with significant unrealized capital gains. Here are the basics principles of tax loss harvesting.
The Internal Revenue Service levies taxes on securities that have been sold at a profit. Short-term capital gains (on profits from securities owned one year or less) are federally taxed as ordinary income. This could currently be as high as 40.8% for some taxpayers (the top marginal tax rate of 37% plus another 3.8% for those subject to the net investment income tax.
Long-term gains, for securities held for longer than a year before sale, are taxed at much lower rates of 15% or 20%, though low earners pay no tax on long-term capital gains and high earners might pay the additional 3.8% net investment income tax.
The basic premise of tax loss harvesting is that the IRS allows you to offset your gains with losses. It’s possible to eliminate all of your capital gains tax liability if you record enough capital losses in the year
Here’s where the “harvest” strategy comes in. If you haven’t sold any stocks at a loss but are holding stocks with unrealized losses, then it can be advantageous to sell those stocks now to trigger the capital loss which then offsets the gains already realized from the other security.
Sometimes, the portfolio is better off with the stock pruned from it—the company might have been experiencing fundamental problems and you hadn’t gotten around to making the decision to replace or sell. In these cases, the tax sale frees up cash to find a better opportunity.
In other instances, the company might be experiencing near-term pressures but you remain optimistic about its long-term potential. For these, you can consider the sale as more of a “trial separation” and revisit the stock after a suitable cooling-off period. Most importantly, per IRS rules you cannot repurchase a security or purchase another “substantially identical” security within 30 days before or after the sale date. If you do, the sale becomes a “wash sale” and the capital loss is disallowed.
For long-term focused investors, a 30-day waiting period will often provide an opportunity to repurchase a stock at around the same price at which it was sold. If the share price declines, then it might be more attractive. If the stock rises in price, it might still be a good opportunity. There are never any guarantees, so be aware that your best laid plans might not work out. Always re-evaluate the stock based on its fundamentals and valuation before making any buy decision.
According to the IRS, if you have both short-term and long-term losses, your short-term losses are used first against your capital losses. If, after using your short-term losses, you have not reached the capital loss deduction limit, you can use your long-term losses until you reach the limit.
If you have more capital losses than gains, then up to $3,000 in losses (for joint filers) can offset ordinary income on your federal return.
If you incur more than $3,000 in losses in a single year, you can carry forward the remaining losses to subsequent years to apply to capital gains and then to ordinary income.
What about Tax Gain Harvesting?
These same concepts apply if you have realized capital losses in the calendar year, but no realized capital gains.
While you might decide to simply apply the realized losses to your ordinary income, you might also decide to sell shares of a highly-appreciated stock in your portfolio and have the resulting capital gains be offset by the already-realized losses.
This can have the benefit of reducing exposure to a potentially overvalued stock, or of improving the portfolio’s diversification. You don’t have to sell an entire position, but might sell only enough shares to generate an equal amount of capital gains to your losses. By using the specific lot method of identifying shares to sell, you could unload shares with a higher or lower cost basis depending on your preferences.
Unlike when selling at a loss, there are no restrictions on repurchasing a stock sold at a profit. You could immediately buy that same stock back with a new cost basis and start the counter running on future capital gains.
Finally, if you have sold no securities in the year, but are holding securities with gains and with losses, you could sell shares of both to generate an equal amount of capital gains and losses. This can be useful if you are especially uncertain about the prospects of either (or both) the winners or losers in your portfolio.
Over time, the practical application of tax loss selling can actually improve your portfolio performance by minimizing your tax burden and forcing you to confront uncertainty in your holdings.
Tax regulations are never simple, and there are many unique situations (such as for mutual funds) which not be covered in this brief article. Some additional research or consultation with your tax advisor is recommended. IRS Publication 544, Sales and Other Dispositions of Assets, has the full details.
Reprinted from the December 2021 issue of the SmallCap Informer.
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