What You Need to Know about Tax Loss Harvesting - Rodgers & Associates

What You Need to Know about Tax Loss Harvesting

Year-end tax planning should include a review of your security positions for unrealized losses. An unrealized loss occurs when a security has decreased in value from your purchase price. In itself, an unrealized loss does not have a tax benefit and is not tax deductible. In order to use the loss, the security must be sold, at which point the loss is realized and therefore deductible for tax purposes. The technique of creating these losses for tax planning is called tax-loss harvesting. The proceeds of the sale are often used to purchase a similar (but not substan­tially identical) security in order to maintain exposure to that category of the market.

The federal tax code says that capital losses can be used to offset capital gains. If losses exceed gains, the taxpayer can take up to a $3,000 loss against other income. Any excess loss can be carried forward into future tax years until the loss is used up completely to offset capital gains or other income.

While reducing capital gains might always seem like a good idea, it is important to remember that taxpayers who are married filing a joint return with taxable income less than $80,000 are taxed 0% on long-term capital gains ($40,000 for single filers). Therefore, using losses to reduce gains would not likely be helpful to someone in that situation.

An exception to that could exist for someone with moderate income who is collecting Social Security. The portion of Social Security that is considered taxable is based largely on your other income. Therefore, if you can use losses to reduce your other income, it can also reduce the portion of your Social Security that is taxable. For someone in this situation, a $3,000 capital loss may result in a reduction in taxable income of more than $3,000.

A frequent mistake 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. If the investor sells the security, and waits the 30 days to repur­chase it, they risk a market rally while they wait. The investor can easily end up paying more to buy back the security than they have saved in taxes.

The wash-sale rule can also be triggered when the investor purchases the same security in their retirement account (IRA or Roth IRA) within 30 days from the sale, if their spouse purchases the same security in his or her own account before the 30 days is up, or if the investor purchases a security that would be considered “substan­tially identical” within 30 days in an attempt to maintain exposure to that sector of the market.

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. With so many potential pitfalls, this type of investment and tax planning can become tricky. It is important to work with your financial adviser and tax preparer to help identify the best strategy for you.