Just What is Tax Loss Harvesting and Why Should I Care About It…. And Why Now?
It’s hard to believe that we have never actually written a BLOG or talked with most of you about investment tax loss harvesting but now, unfortunately, is the time. This is a very complicated topic so we will attempt to keep this overview simple and then we will talk to you individually, where applicable, over the next 4 - 6 weeks.
Quite simply, investment tax loss harvesting is selling an investment in a taxable account when you have a tax loss (on paper) and then using that tax loss to offset capital gains from other investments and/or to offset ordinary income. Sounds quite straightforward, but there are guidelines to ensure that the process is done in accordance with both IRS guidelines and your individual long term investment plan.
Just what is it?
As a reminder, the investment capital gain or loss is defined as the difference between the market value on the day the investment is sold and what you paid for it, a.k.a the cost basis. This cost basis includes any dividends or capital gains which have been re-invested in the security while you owned it.
After the tax harvesting loss is applied against capital gains, any additional loss can be applied against ordinary income up to $3K per tax return per year ($1500 per return if married, filing separately) But any excess tax losses can be carried over to future years with no expiration date on the carry-over amount.
The resulting tax benefit applies only to Federal income taxes.
Tax loss harvesting is only done in taxable accounts. In IRA’s, we apply many of the same principles when we rebalance but there is no immediate income tax impact.
What’s the Biggest Watch-out?
The most complicated piece of tax loss harvesting is compliance with the IRS “Wash Sale” rule. Your CPA can provide a lot more information here, but basically the Wash Sale rule says
An investor cannot buy back a security which has been sold with a tax loss or buy a “substantially identical” security for 30 days before or after the tax loss sale, in any account associated with the investor. The IRS will disallow the tax loss if this happens.
The “substantially identical” requirement is quite gray. We tend to be very conservative here. So for example, if an investor sells Home Depot with a tax loss in a taxable account, we recommend waiting 31 days before buying Lowes, even in a different account.
Why Now?
Besides the obvious market downturn which means there are some tax losses to take, there are other reasons for this to be a priority as we head into the last two months of the year.
The security sale with the tax loss must be done by 12.31.2022 to be helpful for your 2022 Federal tax filing.
As bad as the market has been in 2022, after a pretty darn good bull market for the last 15 years, not all of you will actually have a tax loss in a taxable account. In some cases though, we would like to take the opportunity to re-position or re-balance portfolios with more tax-efficient investments while we have the opportunity to do it without creating a large tax bill for you. For example, we might replace a not very tax-efficient mutual fund with a tax loss (or with only a small gain) with a much more long term tax-efficient exchange traded fund. After 30 days of course.
And this is the complicated piece – many mutual funds distribute capital gains at the end of the calendar year. As you know, this distribution is a taxable event, with absolutely no value to the shareholder, so it makes sense to avoid paying taxes on those capital gains if the plan is to sell the fund anyway.