As humans, it’s difficult for us to admit failure. Nowhere is this more evident than when looking at investments. I can’t count the number of times I’ve heard someone tell me that they don’t want to sell a poor performing investment until it gets back to even. Selling an investment at a loss doesn’t always mean you’re giving up on it. And, in taxable portfolios, it can be a sound tax planning strategy.
Harvesting losses, also called tax loss selling or realizing losses, can be an effective way to reduce capital gains taxes, and sometimes your other income tax as well. And as long as you follow some simple rules, you can avoid wash sales and take advantage of tax benefits without significantly changing your asset allocation.
Finally, keep in mind that your portfolio can show losses to Uncle Sam, yet still have positive performance for the year. As always, you’ll want to check your specific situation with your tax preparer.
The source for most of this information is IRS Publication 550. For those of you who think my writing is dry, give that a chance.
Harvest Losses to Lower Taxes
Depending on your adjusted gross income (AGI) and the other capital gains you have incurred this year, selling an asset that has dropped in value could save you a significant amount of taxes.
For example, let’s say you took a chance and bought $10,000 of Keurig Green Mountain at the beginning of the year. Seemed like a good idea at the time, everybody’s got one of those single serve coffeemakers and they’ll need to keep buying those K-cups. Now, however, you’re looking at a 67% loss (source: Barcharts.com) and wondering what went wrong. You can make a little lemonade out of that lemon (coffee out of those coffee grounds?) by selling it and realizing the $6,700 loss. (Please note I’m not making a recommendation to buy or sell Keurig, this is just to illustrate a point.)
You can then use the loss to offset up to $6,700 of other investment gains you’ve made during the year. The tax savings is dependent on a number of factors, the type of asset you sold, your income, and how long you owned the asset. Let’s say your joint income (AGI) is $125,000 and you had profits of $6,700 or more on other stocks you sold and had owned for more than a year. Harvesting the loss on Keurig saved you $1,005 (15% X $6,700) in federal taxes and $385 in state taxes if you live in Virginia.
No Capital Gains? Reduce Your Income Tax
That’s fine if you sold some other stocks at a profit (realized a gain) this year. What if you didn’t sell anything else? You can still make use of the loss, just not all at once. The IRS allows you to deduct up to $3,000 per year in unused losses against ordinary income. And you can carry over any unused losses into future years as long as you live. If you held the asset jointly with your spouse and you file a joint return, then losses can be carried forward as long as one of you is still living.
Typically, this $3,000 deduction against income will save you more money than you would have if you had capital gains. Unfortunately you don’t get to choose what to take the deduction against. If you have capital gains, you must apply investment losses against them first before taking any deductions against income.
Why Not Harvest Losses All the Time?
Some of you may be thinking, since a tax deduction may be taken on anything sold for a loss in the portfolio, why not just sell any time a stock has a loss and then buy it right back? The loss is realized for tax savings and I still own the security.
Beware the Wash Sale
The IRS has considered this too (and you thought all they did in D.C. while sitting in the daily traffic jams was listen to the radio). As part of the rules explaining what constitutes a realized investment losses, it also outlines when an investment loss doesn’t count.
Essentially it boils down to this. If you have bought that stock or other security within 30 days before or after selling it at a loss, you cannot take the deduction. This is commonly called the wash sale rule.
In addition to not being able to buy the same security, you and your spouse cannot buy a substantially identical security, either in the same account or in any other account you hold. This includes retirement accounts such as 401k’s and IRA’s.
The $64,000 Question
So what is a “substantially identical security”. Unfortunately, the IRS provides little explanation. They do say buying options on the stock is considered identical. Stock in a company that has recently went through a reorganization, such as a bankruptcy, is also considered substantially identical.
What to do? You have a number of options. Here are a few:
- Sell the stock, wait 30 days and buy it back.
- Buy additional shares of the stock to double your position, wait 30 days and then sell the original shares to take the loss. You’re back to your original number of shares and were never out of the stock.
- Sell the stock and buy a mutual fund or ETF that invests in the same sector. Wait 30 days, sell the sector fund and buy back the stock. Odds are that the fund owns the stock as part of its portfolio.
Mix and Match
So far we’ve been talking about harvesting losses using the stock market. However, you can use the loss from the sale of one type of asset, like that Keurig stock, to offset the gain from selling other assets such as bonds, real estate, and even collectibles such as artwork or wine.
Tax Losses and Portfolio Performance Are Not the Same
The key concept to remember is performance is calculated as the current market value of the investment less the market value at a previous point in the past. A positive gain in an investment is not subject to tax until it is sold (realized). If the total realized and unrealized gains in the portfolio are greater than the total realized and unrealized losses, the portfolio will have positive performance.
Conversely, from a tax standpoint, only realized gains and losses matter. The tax documents you give your tax professional, called 1099’s, only show those gains and losses. Unrealized gains and losses are not reported.
Every now and then a client comes to me, usually in April after the markets had a nice positive year, and tells me their accountant made some comments about their poor investment performance. What’s usually happened is we’ve been able to harvest enough losses to offset the realized gains, reducing or eliminating any taxes. Once the client realizes that the portfolio made money and yet no tax is owed, I’m back on their Christmas card list.