What Is Tax-Loss Harvesting?
Tax-Loss Harvesting: The act of selling stocks at a deficit in order to neutralize the amount of capital gains tax due on the selling of other securities at a profit is known as tax-loss harvesting.
This method is most commonly used to reduce the amount of taxes owed on short-term capital gains, which are taxed more heavily than long-term capital gains. The method, on the other hand, may be used to offset long-term capital gains.
This method can help an investor’s portfolio retain its value while lowering the expense of capital gains taxes.
The amount of capital gains losses that a federal taxpayer can deduct in a single tax year is limited to $3,000 each year. Additional losses can, however, be carried over into the following year under IRS guidelines.
Understanding Tax-Loss Harvesting
Tax-loss harvesting, also known as tax-loss selling, is a method of reclaiming losses from the IRS. It can be done at any time of year, but most investors wait until the end of the year to evaluate their portfolios’ annual performance and its tax implications.
An investment that has lost value might be sold to claim a credit against earnings obtained in other assets via tax-loss harvesting.
Tax-loss harvesting is an important strategy for many investors when it comes to lowering their overall taxes. Although tax-loss harvesting will not bring an investor back to their original position, it will help to mitigate the severity of the loss. For example, a decrease in the value of Security A could be sold to offset an increase in the price of Security B, so removing Security B’s capital gains tax burden. Investors can save a lot of money by using the tax-loss harvesting approach.
Maintaining Your Portfolio
Getting rid of a loser in a portfolio has clear benefits. However, it invariably throws the portfolio’s balance off.
Investors that have carefully structured portfolios replace the asset they have sold with a similar asset after tax loss harvesting in order to maintain the asset mix and predicted risk and return levels of the portfolio.
But be wary of repurchasing an asset you just sold at a loss. Investors must wait at least 30 days before purchasing an item that is “essentially comparable” to the asset that was sold at a loss, according to IRS guidelines. You will lose the ability to write off the loss if you do so. The notorious “wash-sale rule” applies here.
The Wash-Sale Rule
For the average investor, the wash-sale rule is simple: avoid buying the same stock that was just sold at a loss for tax purposes.
The rule, on the other hand, is intended to address more exotic tax-loss harvesting schemes.
A wash sale is a transaction in which one security is sold and a “substantially identical” stock or security is purchased within 30 days (either before or after the sale), either directly or indirectly via a derivatives contract such as a call option. A wash-sale transaction is one that cannot be utilized to offset capital gains. Regulators can also levy fines or prohibit an individual’s trading if wash sale laws are broken.
The Wash-Sale Rule and ETFs
Using ETFs in a tax-loss harvesting scheme is one approach to evade the wash sale regulation. Because there are now multiple ETFs that track the same or similar indexes, they can be swapped out without breaching the wash sale rule.
If you sell one S&P 500 index ETF at a loss, you can reinvest the proceeds in another S&P 500 index ETF.
Example of Tax-Loss Harvesting
Assume an investor makes enough money to qualify for the highest capital gains tax bracket. More than $445,851 if single, and $501,851 if married filing jointly for the 2021 and 2022 tax years.
The investor realized long-term capital gains after selling investments, which are taxed at a rate of 20%.
For the year, the investor’s portfolio gains and losses, as well as trading activities, are listed below:
- Mutual Fund A: $250,000 unrealized gain, held for 450 days
- Mutual Fund B: $130,000 unrealized loss, held for 635 days
- Mutual Fund C: $100,000 unrealized loss, held for 125 days
- Mutual Fund E: Sold, realized a gain of $200,000. Fund was held for 380 days
- Mutual Fund F: Sold, realized a gain of $150,000. Fund was held for 150 days
The tax owed from these sales is:
- Tax without harvesting = ($200,000 x 20%) + ($150,000 x 37%) = $40,000 + $55,500 = $95,500
If the investor harvested losses by selling mutual funds B and C, the sales would help to offset the gains and the tax owed would be:
- Tax with harvesting = (($200,000 – $130,000) x 20%) + (($150,000 – $100,000) x 37%) = $14,000 + $18,500 = $32,500
How Does Tax-Loss Harvesting Work?
Capital losses can be used to offset capital gains, which is why tax-loss harvesting is popular. In order to pay less capital gains tax on lucrative investments sold during the year, an investor can “bank” capital losses from unproductive investments.
This technique entails selling unproductive investments and replacing them with investments that are relatively similar (but not “essentially identical”) and maintain the portfolio’s overall balance.
If a loss is utilized to offset capital gains taxes, IRS rules prevent an investor from buying the same stock within 30 days.
What Is a Substantially Identical Security and How Does It Affect Tax-Loss Harvesting?
The investor must not breach the IRS’ wash sale rule in order to take advantage of tax-loss harvesting.
That is, the investor cannot sell a loss-making asset and then buy a “substantially identical” asset within the 30-day period preceding or after the sale. The tax loss write-off will be nullified if you do so.
A “essentially identical security” is a security issued by the same company (for example, class A vs. class B shares or a convertible bond issued by the company) or a derivative contract based on the same security.
How Much Tax-Loss Harvesting Can I Use in a Year?
The max amount of capital losses that can be used to balance capital gains in a year is set by the IRS. Individual taxpayers can write off up to $3,000 in short-term losses against short-term gains in a given year. Long-term capital losses are subject to the same $3,000 maximum.
Long-term losses, on the other hand, might be carried over to subsequent years. A $9,000 loss, for example, can be spread out across three tax years.