Year-end tax planning generally includes reviewing currently held security positions that are trading below your cost. This situation is called an unrealized loss. Unrealized losses are not tax deductible. To use the loss for tax purposes, the position must be sold, creating a realized loss. The technique of creating these losses for tax planning is called tax-loss harvesting.
The federal tax code says that capital losses can be used to offset capital gains. If losses exceed gains, the taxpayer can take a $3,000 loss against other income. Any excess loss can be carried forward into future tax years.
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.
One of the frequent mistakes can occur when an investor wants to sell a position to harvest the loss with the objective of buying back the same security. Tax laws require waiting 30 days before repurchasing the same security. Failing to wait 30 days triggers the wash-sale rule, which disallows the loss for tax purposes. The investor sells the security, but the market rallies before the 30 days have passed. The investor can easily end up paying more to buy back the security than they will have saved in taxes.
Keep in mind that you can only take $3,000 in losses, unless you have capital gains. Don’t spend time looking for losses unless you have gains to offset. You should also check your tax bracket. Taxpayers that are married filing a joint return with less than $70,000 of taxable income are in the 15% tax bracket. Long-term capital gains are taxed at zero in this bracket. Harvesting losses to offset gains that wouldn’t be taxed doesn’t make sense.