Tax Loss Harvesting Rules and Examples

If you have a taxable investment account, tax loss harvesting could help you reduce your tax burden. Before the year is out, take a look at your investments and note if you have any losses (realized or unrealized). 

Investments sold at a loss can offset previously realized gains from earlier in the year. But don’t make changes to your portfolio yet. There are limits to how much you can offset, and one very important rule to be aware of…

What is tax loss harvesting?

Throughout the year, you may have sold positions in a taxable account above their purchase price. These sells generate realized capital gains where the difference between the sale price and the purchase price is subject to capital gains taxes (in many cases). Realizing capital losses can offset capital gains. 

EXAMPLE: If you have $1,000 in realized capital gains year-to-date and you decide to book exactly $1,000 in realized losses, the gains and losses will net out and your tax burden from this combination of transactions will be zero. 

Why Realize Losses?
Markets are cyclical, and a well-diversified portfolio will inevitably have different positions that increase in value while others decrease. Obviously, buying positions that go down in value is never the goal of building an investment portfolio. However, it is not realistic to expect that a properly diversified portfolio will never have a single position ever fall below its purchase price. Think of loss harvesting as a potential silver lining to an investment that falls below its cost.

Other Benefits of Tax Loss Harvesting

• If realized losses exceed realized gains in a given year, you can use these excess losses to offset up to $3,000 of ordinary income in that year.
• For losses above and beyond $3,000, those additional losses can be carried forward to future years and potentially offset ordinary income in those future years (up to $3,000 each year).

The Wash Sale Rule

When utilizing a tax loss harvesting strategy, you must be mindful of the wash sale rule. The wash sale rule states that if you sell a security at a loss and buy the same security or a “substantially identical” security within 30 days before or after the sale, then that loss will be disallowed. In other words, once you sell a security at a loss, you must wait at least 30 days to buy the position back.

EXAMPLE: If you sell stock in a semiconductor company at a loss, you could purchase a technology sector ETF and use that holding as a placeholder for 30 days (or longer, if you choose). The ETF can offer similar market exposure, and you can potentially participate in a rally of that particular sector. Once the 30 days are up, you can sell the placeholder ETF and re-buy the position sold at a loss and/or a similar company. 

Limitations to Loss Harvesting

• Loss harvesting can only be done in taxable accounts. You cannot offset a previously realized gain in a taxable account with a loss in a non-taxable account like a 401(k) or an IRA.
• Navigating wash sales can be tricky and time-consuming, especially for a well-diversified portfolio with dozens or even hundreds of individual tax lots.

It may make sense to consult a financial planner and/or tax expert for assistance in navigating the complexities of a tax loss harvesting strategy.

Does it ever make sense to harvest gains?

In some situations, it may make sense to harvest realized gains actively. For a married couple with a taxable income under $94,050, the tax rate on long-term capital gains is 0%. For a single filer, the threshold for a 0% long-term capital gains rate is $47,025 (half of $94,050) of taxable income.

EXAMPLE: A recently retired couple might have lower taxable income in their early retirement years and could realize just enough long-term capital gains each year to stay in the 0% long-term capital gains tax bracket. They could sell a stock held in a taxable investment account with a long-term gain (held for longer than one year) and then buy back that recently sold stock to reset their cost basis and potentially lower their tax burden in the future.

It makes sense to work with an experienced Wealth Manager and/or tax advisor to implement a tax gain harvesting strategy since a crucial aspect of the scenario above is to realize gains while being careful to stay in the 0% long-term capital gains tax bracket.

Questions? Let us know…

Tax loss harvesting (or gain harvesting) is easy to understand, but the execution involves navigating several complexities, such as:

• Determining which positions to sell at a loss
• Avoiding wash sales for every transaction
• Choosing placeholder securities for each position sold.

We’re here to help. Connect with us online or give us a call at (415) 541-7774.

Related Reading:

• Year-End Financial Planning Checklist
• 5 Ways to Minimize Taxes
• How to Reduce Taxable Income Through Charitable Giving

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