Reduce Taxes through Tax Loss Harvesting
Investors do not welcome down markets, but they can take advantage of them. In addition to looking for great buying opportunities when securities prices have declined, investors should consider reducing their current or future tax bills through tax loss harvesting.
Tax loss harvesting allows investors to sell assets at a loss and use the loss amount to offset current and/or future taxable gains. Short-term losses (the sale of assets held for under 365 days) can be used to offset tax on short-term gains (assets bought and sold within 365 days). Long-term losses can be used to offset tax on long-term gains. For example, if you take a $25,000 loss this year but you realize a $25,000 gain from selling a different security, the loss will wipe out the tax liability that would otherwise be associated with the gain. If there is a remaining loss after offsetting any long-term gains, you can use up to $3,000 (for married couples filing jointly) to offset ordinary taxable income. Any remaining losses can be carried forward, indefinitely into future years, until all the losses are deducted. There is no limit on the amount of long-term capital gains that can be offset each year, and past losses can continue to offset ordinary taxable income up to $3,000/year.
Those who want to keep the balance of their portfolio intact while still doing tax loss harvesting may buy back the same security after 30 days OR buy a similar security immediately. When buying a similar security to replace a sold, loss-generating security, one must beware of the Wash-Sale rules. Wash-sale rules exist to prevent investors from selling a losing asset simply for the tax savings and then buying the asset right back. Investors who do not know how to navigate the wash-sale rules may find themselves with an unexpected tax liability if the IRS disallows their loss.
The IRS will disallow a loss if, within 30 days before or after selling a security, an investor replaces a loss-generating security with the same security, a “substantially identical” security, or an option to buy the same security. Investors may not circumvent the rule by selling and buying identical securities in different accounts either. Tax advisors also generally advise spouses to avoid violating the wash-sale rules as the IRS would likely view spouses as a single investor for the purpose of enforcing the rules.
When someone violates the wash-sale rule, the IRS prohibits the person from writing off the loss and requires the investor add the loss to the cost basis of the newly purchased security. The latter “penalty” can actually work to someone’s advantage by reducing the amount of capital gains tax owed later or allowing for a greater loss to be claimed later. Still, people typically want to avoid running afoul of IRS rules.
Tax loss harvesting can be a way to mine some benefit from a down market year; however, the strategy is not for inexperienced investors. You should always consult with a tax professional when considering whether tax loss harvesting could benefit you. Everyone’s circumstances are different. A wealth advisor can help you understand the wash-sale rules and how to replace a sold security with an asset that preserves your portfolio’s intended design if that is your goal.
At Pacific Wealth Management, we evaluate our clients’ portfolios and implement a tax-loss harvesting strategy where it makes sense. We coordinate with clients’ tax advisors and ensure that we are considering the totality of someone’s financial picture before we initiate tax loss harvesting. The strategy is not for everyone, but it can be a silver lining during years like 2022 when most people have experienced losses in their portfolios but know they will likely have future gains to manage.