Q: My investment advisor contacted me last week to let me know he was going to be doing some “tax-loss harvesting.” He said the bear market had “opened up an opportunity to take losses” as if losses were a good thing. I didn’t understand what he was trying to tell me or how the losses were going to help me. Can you explain it for me?
A: Tax-loss harvesting is simply an opportunity to make lemonade when the market turns sour. To be clear, taking a loss is not usually our first choice. It would be much better if every investment we made always went up. Unfortunately, that isn’t the case. When a bear market hits and asset prices drop, tax-loss harvesting can be a smart portfolio management move in a taxable account.
The basic idea is to sell a capital asset at a loss and immediately reinvest the proceeds into something similar to maintain your market exposure. Tax-loss harvesting is not market timing, so maintaining market exposure is vital. The loss you realize on the sale can be used in a number of ways. First, it can be used to offset any capital gains you may have already realized. Second, it can be held indefinitely to offset capital gains you may recognize in the future. Third, a small portion (currently up to $3,000 per year) can be deducted from ordinary income on your tax return.
Harvesting portfolio losses is not a free lunch. By that I mean it does not give you a tax benefit that you wouldn’t otherwise have. It just gives you more flexibility. Consider the following example.
Let’s suppose I buy Stock X for $100 and its value drops to $40. I sell the stock and harvest a $60 loss. To maintain my exposure in the market, I simultaneously take the $40 I received from selling Stock X and buy Stock Y.
Now let’s suppose the market recovers completely and both Stock X and Stock Y are worth $100. My position in Stock Y now has a capital gain of $60—exactly equal to the loss I took when I sold Stock X. In other words, if I sell Stock Y, I can use the tax-loss I harvested when I sold Stock X to offset the gain on Stock Y. My net tax liability will be zero.
Note that this is exactly the same outcome I would have had if I had simply held onto Stock X and waited for the market to recover. However, by doing tax-loss harvesting, I generated a loss that I can use to offset capital gains generated anywhere else. For example, losses harvested from my stock portfolio could be used to offset gains on the sale of my house.
When you do tax-loss harvesting, you need to be aware of potential pitfalls. The most onerous pitfall is known as the wash sale rule. A wash sale occurs when you sell an asset at a loss and buy the same asset or a “substantially identical” asset within 30 days before or after the date of the sale. If the IRS deems you to have done a wash sale, you will not be able to deduct the loss on your current-year tax return and the basis on your new investment will be adjusted upward by the amount of the wash sale loss. The holding period of your new investment will also be lengthened by the amount of time you held the wash sale asset.
The wash sale rule is fraught with ambiguity. The IRS, for example, does not define the term “substantially identical.” As a result, market participants should be very careful when they select the assets they will buy as part of their tax-loss harvesting transaction.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have about investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.