Tax Loss Harvesting: Don't Lose Sight of Your Long-Term Strategy - Rodgers & Associates

Tax Loss Harvesting: Don’t Lose Sight of Your Long-Term Strategy

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No one ever expects to lose money on an investment but the reality is that everyone’s portfolio will probably have losers at some point. We diversify our invest­ments to hedge ourselves with the goal of having enough winners to more than offset the positions that aren’t working out. One way to make the best of poor performers is by utilizing the tax break that comes with selling an investment for a loss. In tax speak this is called realizing a capital loss. Tax savvy investors often utilize a planning technique called loss harvesting before the end of a calendar year to minimize taxes. This week we’ll review the proper way of deducting capital losses to maximize tax benefits.

An investment you paid $10,000 for that is now worth $9,000 is considered an unrealized loss because you still own it. Unrealized losses have no tax benefits. Once you sell this investment for $9,000 you have realized a loss of $1,000. The loss is deductible if the investment was held in a taxable account. The loss is a short-term loss if you held the investment for less than one year. The loss becomes long-term after one year of ownership.

Gains and losses from the sale of securities are considered capital gains or losses and are reported on tax form Schedule D. Short-term gains & losses are netted out in the top section and long-term gains & losses are netted in the bottom section of this form. Finally, long and short-term capitals gains (losses) are totaled up and carried to the first page of your tax return — Form 1040. If the net amount is a loss, only $3,000 can be used in any one year to offset other types of income. Any loss in excess of $3,000 can be carried to the next tax year and used to offset gains until the loss is used up.

Tax loss harvesting should be done properly in order to take full advantage of the tax benefits and not cause damage to your investment strategy. Here are some important points to keep in mind:

  • You should approach tax-loss harvesting cautiously. It is easy to get lost in tax impli­ca­tions and lose sight of your overall financial goals. Tax-loss harvesting also has the potential to create havoc with your investment strategy. You should always begin with your investment strategy in mind and harvest losses where an investment change could enhance your portfolio as well as your tax situation. The first priority should always be investment perfor­mance. Don’t let taxes get in the way of making smart investment decisions.
  • You can only take $3,000 in net losses. Don’t spend time looking for losses of more than $3,000 unless you have other capital gains to offset.
  • Check your tax bracket before engaging in tax loss harvesting. The tax rate on long-term capital gains is zero for taxpayers in the 15% tax bracket. Harvesting losses to offset gains that wouldn’t be taxed usually doesn’t make sense.
  • Be aware of the wash-sale rule. Tax law requires waiting 30 days before repur­chasing the same security you sold for a loss. Failing to wait 30 days triggers the wash-sale rule, which disallows the loss for tax purposes.
  • Consider potential investment risk versus any tax benefits received. The investor sells a security to realize the loss with the objective of buying it back after 30 days. The market could rally before 30 days have passed. The investor could pay more to buy back the security than they saved in taxes.

Tax loss harvesting usually makes sense to offset a very large gain. It can also make sense for those taxpayers subject to the Medicare surtax or when Social Security benefits become taxable, due to realized gains. This strategy does not perma­nently avoid taxes. It defers them by lowering the cost basis when the proceeds of the sale are reinvested. This strategy should ideally be used when the investor would want to sell the security anyway. Perhaps the position has been under­per­forming or doesn’t meet investment objec­tives anymore. The investor’s portfolio is reposi­tioned and tax benefits become a bonus.

Capital gain harvesting is another tax planning technique although not as commonly used. The concept is to sell appre­ciated securities that you’ve held for at least 12 months to realize the long-term gain for tax purposes. You can immedi­ately repur­chase the same asset because there is no wash sale rule for realizing gains. This allows you to pay tax on the gain in a year when your income is low and establish a new cost basis in the asset to minimize increased gains that may be taxed at higher rates.

Anyone in the 15% tax bracket should consider realizing gains up to the top of the 15% tax bracket because long-term capital gains are taxed at 0%. This strategy may also appeal to taxpayers subject to the Medicare surtax in some years. They may want to harvest gains in years their income will be under the surtax threshold. Those living in states that tax capital gains will need to take into consid­er­ation the state tax impli­ca­tions of this strategy.

Rick’s Tips:

  • Unrealized losses have no tax benefits. Selling an investment creates the tax event.
  • Begin with your investment strategy in mind and only harvest losses where an investment change could enhance your portfolio as well as your tax situation.
  • Capital gain harvesting can be advan­ta­geous to investors in a 15% tax bracket because long-term gains are taxed at 0% in this tax bracket.