Well, it is that time of year. I am not referring to the grand holidays, no. It is the time of year when professional money managers look for opportunities to harvest tax losses. As you might suspect, this is also the time of year when many clients call and ask about tax loss harvesting. It sounds like a simple process, but it is complicated and if executed improperly it can have a less-than-desirable effect… in other words, you can end up with a bigger tax bill than expected. So, let’s take a look at what tax loss harvesting is along with its benefits, drawbacks, and risks. But, before we get started, if you are interested in tax lost harvesting for yourself, you should consult a tax expert.
What is tax loss harvesting?
Before we get into harvesting, we have to understand what capital losses are and what are the implications. A gain or loss is calculated by subtracting the sale value of an investment from the cost of the investment (cost basis). A gain is when an investment is liquidated at a higher value than it cost and vice versa for a loss. For example, if you purchase stock for $10,000 (cost basis) and sell it for $12,000, you will have a capital gain of $2,000, which is subject to taxation in the year you make the sale. You are probably well aware of this scenario as most of us enter investments to make profits, but what if you end up selling your investment for $8,000? Well, you would have a capital loss, and a bruised ego. But it’s not all bad, there may be a silver lining. The IRS will allow you to offset your other capital gains in order to minimize your overall capital gains tax for the year. Moreover, you may even be able to apply some of your loss against your income.
For example, let’s assume that you had a $4,000 capital gain from a transaction earlier in the year. Your recent capital loss of -$2,000 can be applied to that earlier gain making your total taxable gain for the year only $2,000. Assuming a long-term capital gains tax of 15%, by taking the loss, you would have saved yourself $300 in Federal taxes. That may not seem like much, but if you invest that money, it will grow and compound over time. That is why the IRS allows the offset, to incent investment. The math is simple:
15% * ($4,000 – $2,000) = $300 in tax savings
Here is where things get a bit more interesting. If you have capital losses which exceed your capital gains in the year, you may be able to subtract up to $3,000 from your income, thus lowering your Federal Income Tax earned. If you still have additional capital losses after offsetting capital gains and $3,000, the IRS will allow you to carry forward those losses indefinitely to be used in the future.
Because capital losses have so much potential benefit, some investors choose to intentionally lock in unrealized losses by closing a position thus making those losses realized. That is the basis for what is known as tax loss harvesting. You may choose to sell a losing position because you wish to find another investment with better potential, but if you sell a position expressly to realize a loss, it becomes the first part of a tax loss harvesting transaction, which is perfectly legal. Because the transaction was conducted expressly to realize a loss, some investors will use the proceeds of the transaction to buy a similar position in order to continue to benefit from the original investment. So, a tax loss harvest looks like the following:
✓ Sell a position that has an unrealized loss
✓ Harvest the now realized loss to be applied to capital gains and income
✓ Purchase a stock or ETF with similar properties to the originally sold stock
In this harvesting scenario, the investor believes that the similar position will trade higher in a manner similar to if the original position were never sold, but in this case, the investor harvested a tax loss.
Important things to recognize in Tax Loss Harvesting
As you are probably well aware, the Government is not in the habit of giving out passes on income taxes, but based on our discussion so far, you are probably thinking that tax loss harvesting is a gift from the IRS. Come on, you know better. There are a number of very important things that you have to consider when contemplating TLH, and once again, I am presenting these to you as a basic overview. You must speak with a tax professional, like your accountant for starters, before you embark on any TLH transactions.
Tax deferral only
The first important consideration is that tax loss harvesting is simply a way of deferring taxes. “What do you mean, Mark,” you are thinking. Let me explain. If you sell a stock at a loss, realize the loss, and then purchase a similar stock in its place, when that alternative stock rises once again, you will have a realized gain from the get-go. Remember, your original cost basis for the losing stock was higher than when you realized the loss. So, yes, you are saving on taxes this year, but when you liquidate the alternative stock in the future, you will pay gains taxes, assuming it goes up. Now that we understand that there will be a new cost in the future, we have to conduct a more exhaustive analysis to determine if a TLH transaction is beneficial.
It does not always work in our favor
It is important to realize that a tax loss harvesting transaction lowers the cost basis of your investment. While realizing a capital loss will help with this year’s tax, it may cause a larger tax in the future. Let’s use an example to illustrate.
Let us say that you purchase $20,000 worth of Cisco Systems (CSCO) stock in March of 2019. When the market swooned in response to the onset of COVID in 2020, your position had an unrealized loss of around -30% by mid-March. You decide to sell your position and harvest the -$6,000 unrealized loss, so you sell all your CSCO stock for $14,000. You then take the proceeds and invest them in the Technology Select Sector Spdr ETF (XLK) because it is similar, and you believe that it will give you continued exposure to the tech sector. Realizing that loss, you have managed to save $900 in capital gains tax (assuming you fit into the 15% LTCG category). Same simple math as above.
15% * ($20,000 – $14,000) = $900 in capital gains tax savings
This is where you need to pay close attention. Your new position of XLK has a cost basis of $14,000, considerably lower than your original CSCO cost basis of $20,000. Let’s proceed with our example. You ride out the pandemic with your position of XLK, which at one point gained over +100% from when you purchased it back in 2020. But now in December of 2022, the position has lost a bit of value with all the Fed rate hikes and market pullbacks. You decide to take your profits while the going is good, so you liquidate your position for $21,000. You have just realized a $7,000 long-term capital gain because of the reduced cost basis from the original investment. Assuming that you are still in the 15% long-term capital gains tax bracket you would owe $1,050 in capital gains tax, which not only wipes out your original $900 in savings, but it ended up costing you $150 more in tax.
15% * ($21,000 – $14,000) = $1,050 in capital gains tax now owed
Now, you may not fret over $150 extra in taxes owed, but our example shows us that tax loss harvesting doesn’t always work. Additionally, our example had us buying an ETF which performed better than our original stock, CSCO. What if we decided to purchase in Intel (INTC) in March of 2020? Our position today would only be worth around $8,400. Ouch! We could seek to harvest the additional tax loss… which could save us money in this year’s taxes, but, as we learned, it will lower our cost basis even further and subject us to much larger capital gains taxes in the future.
Short-term vs. long-term capital gains
Up until now, we have focused our discussion on long-term capital gains because of their simplicity, but it is important to recognize that long-term capital gains are taxed at a different rate. According to the IRA a long-term investment is classified as one held for more than 1 year while a short-term investment is one held for less than 1 year. Federal long-term capital gains are taxed at 15% or 20% depending on your income. Short-term capital gains are taxed as ordinary income at the marginal tax rate which can be as high as 37% based on your taxable income. It is therefore almost certain that you will pay more for short-term capital gains than long-term ones. Investors must think carefully about taxation when deciding when to take profits and where to apply their harvested losses. Furthermore, each state has its own capital gains taxes which can also affect your overall tax bill at the end of the year. You know what I am going to say next, right? You should speak to your accountant or a tax expert before embarking on any potential tax-based transaction.
Rules of the road
As we saw up above, tax loss harvesting simply defers taxation until the ultimate position is liquidated. In other words, the IRS always gets its share at the end of the day. Further, the IRS has rules associated with tax-loss harvesting.
Income tax deduction
The IRS allows you to deduct up to $3,000 of your capital losses from your income. Any excess can be carried forward to be used in future years.
Losses must first offset similar gains
Losses of one category must first be exhausted within its class before it can be applied to another. For example, if you harvest long-term losses they must first be applied to long-term gains. Any excess can then be applied to short-term gains. Similarly, short-term losses must first offset all short-term gains before they can be applied to long-term gains.
This rule states that an investor cannot repurchase the same security or a substantially similar security to the one sold in a tax-loss harvest within 30 days before and 30 days after. In the case of our example above, if you re-purchased CSCO two weeks after locking in your loss in March 2020, you would trigger a wash-sale violation. A substantially similar security would be selling Alphabet’s C Class shares (GOOG) and buying Alphabet’s A Class shares (GOOGL). It is therefore best to stick with the replacement investment for at least a month after the tax-loss was harvested. If you have questions about timing and similar securities, you should contact your brokerage firm’s operations representative.
While the ability to offset capital gains or income with capital losses is a powerful tool, tax loss harvesting may not always be in the investors’ best interest. Many debate the usefulness of tax loss harvesting, because while it can put more money to work (tax savings) and ultimately return more to the investor, harvesting does not always work in favor of the investor. If it does, the client will ultimately end up paying taxes on the gains when an account is liquidated into cash. Further, going from one investment to another, even to realize a tax saving, means shifting potential returns, ultimately adding additional potential risk. As demonstrated by our example above, the net result in tax loss harvesting could end up costing the investor more at the end of the day. Speak to your accountant or a tax expert if you are interested in pursuing tax loss harvesting.
Muriel Siebert & Co., LLC is an affiliated broker/dealer of the public holding company, Siebert Financial Corporation, which also owns Siebert AdvisorNXT, LLC. Siebert AdvisorNXT, LLC is a registered investments advisor (RIA) with the SEC and with state securities regulators. We may only transact business or render personal investment advice in states where we are registered, filed notice or otherwise excluded or exempted from registration requirements. Investment Advisor products are NOT insured by the FDIC, SIPC any federal government agency or Siebert’s parent company or affiliates.
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