Believe it or not, year-end is right around the corner which means that it’s time for investors to start thinking about their tax implications. In order to help you make sense of it all, we wanted to share this article originally published last year by guest blogger Steve Thorpe. Enjoy–
Would you invest a few short hours to reduce this year’s taxes by $1,000 or more? For investors with taxable investment accounts, this is often possible by taking advantage of tax loss harvesting (TLH). This perfectly legal strategy makes lemonade from lemons, allowing Uncle Sam to share part of the pain of the losses inevitably experienced by investors at some points during their investing career
Between now and the end of the year is a good time to review your portfolio to see if any of your holdings are in the red. If so, you might be able to use those losses to help lower your 2010 tax bill.
In this article I’ll review:
- How to harvest a tax loss and under what circumstances you might want to.
- Why you need to keep track of what your investments cost in the first place.
- How to properly rebalance your portfolio after a sale, without triggering undesirable tax consequences.
- The way investments look from a tax perspective: short-term losses can be more valuable than long-term losses. But hold onto gains at least a year and a day.
From time to time, an investment will fall below its initial purchase price. If it’s held in a taxable account then this could be a TLH opportunity. TLH entails selling the underwater security to realize the loss, and then buying a similar but not substantially identical security to replace it. Assuming it makes sense given an individual’s personal tax and asset situation, then TLH can be implemented.
TLH can result in lower income taxes during the current or future years, and/or allow an investor to sell other securities that have gone up in value without incurring as high a tax bill. The second step, purchasing the similar but not substantially identical replacement security, maintains the investor’s desired asset allocation.
If you sell a security for less than what you originally paid for it (the “cost-basis”), you have a capital loss. Conversely, if you sell a security for a higher price than you originally paid for it you have a capital gain.
If your overall capital losses exceed your capital gains, the excess can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000 (or $1,500 if you are married filing separately). If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over unused short-term and long-term losses to subsequent years, “using up” the losses year by year until they are gone.
Assume your marginal tax rate (combining federal plus state) is 30%, and you owned a security for less than one year that was originally purchased for $40,000 and was then sold for $45,000. Good news – you’ve got a $5,000 gross profit! Of course based on that 30% tax rate, $1,500 of that short-term gain would normally go to income taxes. (You pay taxes at your marginal ordinary income tax rate on any gains on securities held less than a year. Gains on securities held more than a year are taxed at your long-term capital gains rate, which is usually lower. More on that later.)
However, suppose you have another security, also owned for less than one year, that was purchased for $50,000 and is currently underwater with a value of $43,000. By selling the underwater security, a short-term capital loss of $7,000 is realized. The $7,000 loss completely offsets the $5,000 gain, leaving a $2,000 loss that can be deducted against ordinary income on your tax return. The net $2,000 loss translates to a $600 reduction in this year’s income taxes. By booking the loss, you owe $600 less in taxes instead of $1500 more in taxes – a net savings of $2,100 in this example.
Tracking Your Share Lots
TLH is optimally implemented with certain cost-basis tax methods. Ideally, the “specific share” identification method is used as it gives the most fine-tuned method of control. For example, when selling securities with TLH in mind, it is usually best to sell the lot(s) (meaning the set of shares bought at a given time and price) with the highest cost-basis. That way you minimize the capital gain if it’s a winner, or maximize the capital loss if it’s a dud.
However, when donating long-term appreciated securities to charity, just the opposite is true. Then it is usually best to donate the lot(s) with the lowest cost-basis, thereby allowing maximal tax efficiency since the charity will never pay taxes on the appreciation while the investor typically can deduct the entire donation.
A potential disadvantage of using the “specific share” identification method is the extra record-keeping effort it requires. Some brokers do ease this process with convenient web-based technology.
A detailed discussion of cost-basis methods is beyond the scope of this article. For additional information including the specific methods and associated requirements, the reader is referred to:
- IRS Publication 550 “Investment Income and Expenses”
- IRS Publication 551 “Basis of Assets”
- IRS Publication 564 “Mutual Fund Distributions”
Beware of the Wash Sale Rule
Recall I mentioned buying a similar but not substantially identical security to replace the sold security, in order to maintain your desired asset allocation. The IRS regulations include what is known as the “wash sale rule” that prevents you from buying back the same security right away if you want to take advantage of a harvested tax loss.
You cannot deduct losses from sales or trades of stock or securities in a wash sale. A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical stock or securities
- Acquire substantially identical stock or securities in a fully taxable trade
- Acquire a contract or option to buy substantially identical stock or securities, or
- Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA
If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.
Markets tend to fluctuate wildly in short periods of time, so if you simply sit out of the market for 31 days before once again buying a position in the same security, it is very possible you’ll miss out on a significant market change. Consequently, it is often advisable when using TLH to maintain a chosen asset allocation policy by immediately buying a similar but not identical replacement security.
For example, if you took a loss in Vanguard’s S&P 500 Index fund, you might wish to replace it with the Vanguard Large Cap Index fund. Similarly, IBM stock might be replaced with HP. The key is to pick a similar security that you’d be perfectly happy to keep for the long haul (even after 31 days), because if a significant gain occurs during that time it would be best to hold onto that, rather than sell it and owe taxes.
Favor Losses to be Short-Term and Gains to be Long-Term
Capital gains and losses are all reported on your federal (and possibly state) tax return, and classified there as long-term or short-term depending on how long you hold the property before you sell it. If you hold it more than one year, your capital gain or loss is classified as long-term. If you hold it one year or less, your gain or loss is short-term. On your tax return, long-term gains and losses are combined to calculate your net long-term capital gain or loss. Similarly, short-term gains and losses are combined to calculate your net short-term capital gain or loss.
For most taxpayers, the tax rates applied to long-term capital gains are lower than those applied to short-term capital gains. Accordingly, gains are usually best realized only after holding a security for more than a year, if possible. Since short-term capital gains usually imply a higher tax rate on the gain, it is usually a good idea to offset them when possible, by selling any underwater securities you’ve held for one year or less. Note that it is always worth considering realizing losses even when they will be classified as long-term (held longer than one year), as those too can benefit one’s tax situation.
Remember, when possible, long-term capital gains are preferable. Whereas it’s better to realize losses in the short-term if possible. Note that to be considered long-term, the asset must have been held for more than one year, that is, at least one year and a day. If held for exactly one year (or less), it would be classified as short-term.
Here is an example from IRS Publication 550 “Investment Income and Expenses”:
To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period.
Example: If you bought investment property on February 5, 2008, and sold it on February 5, 2009, your holding period is not more than 1 year and you have a short-term capital gain or loss. If you sold it on February 6, 2009, your holding period is more than 1 year and you have a long-term capital gain or loss.
Reviewing Portfolios for Tax Loss Harvesting Opportunities
During the 4th quarter of every year, you’ll inevitably see articles featuring year-end tax strategies that remind investors to check their accounts for possible TLH opportunities. The 4th quarter is definitely a great time to review your portfolio as potential TLH savings for the tax return due next April 15 would need to be implemented no later than December 31 of this year.
Checking more often than annually for TLH opportunities is also a useful strategy, since equity valuations are volatile and some valuable TLH tax saving opportunities could be missed entirely if you only look at this once a year. For example, on March 9, 2009 the S&P 500 index closed at 676.53. Less than 10 months later on December 31, 2009, the index had risen almost 65% to close out the year at 1115.10. Investors who frequently reviewed for loss harvesting opportunities were more likely to realize significant benefits – especially around the bottom of the market. Of course that market swoon was an extreme example, but you get the point. Market losses (TLH opportunities) do not conveniently limit themselves only to the 4th quarter.
The frequency of portfolio reviews needs to be balanced against the level of effort required. Perhaps a convenient strategy for many would be to check monthly or quarterly.
Automated tools may be able to help ease the drudgery of keeping up with unrealized losses to potentially harvest. For example, certain versions of the popular personal finance software Quicken help with tracking cost basis. Many brokers and mutual fund companies have online tools to assist with tracking capital gains and losses. There are even freely available tools that can be used with Microsoft Excel to automatically download current stock quotes into a custom designed spreadsheet with taxable share lots.
How do you know whether you have a loss that could be worth harvesting?
There are no hard-and-fast rules here, though generally if the value of the tax benefits would significantly exceed the costs of harvesting the loss, you have a good candidate for TLH.
Remember, any transaction fees and commissions, possible bid-ask spreads and the value of your own time all figure into the costs. Capital losses of say greater than $1000 might be a reasonable trigger point for some investors, as they could have a potential tax benefit of several hundred dollars or more. Higher marginal tax brackets carry more incentive to harvest losses due to the greater tax benefit. Large taxable portfolios with many different positions tend to present more beneficial and frequent TLH opportunities. Investors in low tax brackets usually derive smaller benefits from TLH. Finally, investors with all their investments in tax-advantaged accounts such as 401Ks, Traditional IRAs, or Roth IRAs need not worry about TLH at all since they can’t benefit from these strategies.
Some reminders regarding portfolio reviews:
- Reviews for TLH opportunities are best done periodically throughout the year, with harvesting implemented whenever the benefits significantly outweigh the costs
- It’s a good idea to do a review during December, in case there are final harvesting opportunities for that taxable year
- If you have an unrealized loss that is short-term, it’s usually best to realize it before it becomes long-term
- If you’re considering realizing a gain, think about waiting until the security has been owned more than one year so the gain is eligible for the more favorable long-term capital gains tax treatment
- Remember not to get trapped by the wash sale rule! Replace securities sold at a loss with similar but not substantially identical securities
- Closely track the cost basis of all share lots to maximize TLH benefits when choosing which losses to harvest
- Weigh the potential tax savings from harvesting a tax loss vs. the various costs, to decide whether it’s worth the effort
Its impossible to reliably predict future changes within the investment markets, however there are numerous ways for investors to favorably influence their own results. Important areas to focus on include developing an investment plan, saving regularly, diversifying widely, adhering to an appropriate asset allocation, and paying attention to all forms of costs – including taxes. For many investors, the tax loss harvesting techniques discussed in this article can improve their after-tax bottom line, sometimes to the tune of thousands of dollars per year.
Every individual’s situation is unique, tax laws are complex and always changing, and this article provided only a few examples on topics that have many subtle nuances not discussed here. Therefore, this article should be considered general educational information only and not in any way specific recommendations customized to any individual’s circumstances.
For further information, you may wish to check the IRS web page “10 Facts About Capital Gains and Losses”, which has some guidance and links to many related IRS publications. You can also find an extraordinarily kind and knowledgeable volunteer community ready to help at bogleheads.org, a free, moderated forum dedicated to the civil discussion of investing, personal finance, and consumer issues. The Bogleheads site also includes a wiki with a discussion of investment related tax considerations that’s much more detailed than this article.
Most importantly, the reader is advised to consult a licensed tax professional to best understand how to apply these techniques to their own unique situation.
About the Author
Steve Thorpe is the founder of Pragmatic Portfolios, LLC, a fee-only Registered Investment Adviser based in Durham, North Carolina that focuses on developing sensible investment plans integrated across all of a client’s investment accounts. He also chairs the Research Triangle Park, NC area chapter of the “Bogleheads” investment interest group. Observing conflict-of-interest laden behavior of various charlatans from Wall Street has always inspired Steve to help others navigate the sometimes-treacherous investment landscape. Building upon his lifelong fascination with investing, he has been advising clients, business associates, family and friends for years.
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