Tax Loss Harvesting: It’s Not For Everyone, But Is It For You?

Tax loss harvesting sounds like something you might do in the garden during the fall. But it’s actually an advanced tax strategy that uses investment losses to reduce your taxes . How does it work? Tax loss harvesting is essentially just selling a security (stocks, bonds, mutual funds, exchange traded funds, etc) you own that is currently worth less than what you bought it for. Why would you intentionally sell something at a loss? Because that realized loss can offset current or future gains and up to $3,000 of ordinary (non-investment) income so you will pay less taxes. If you want to maintain your basic investment mix and portfolio makeup you can take the proceeds from selling at a loss and purchase a similar (but not the same) security.

Let’s say you own three stocks: Alpha, Beta, and Delta. Alpha and Beta are up for the year (worth more than they were) and you decide to sell Alpha only. That generates a capital gain. Since you didn’t sell Beta, there is no realized gain. Delta is down for the year (has lost value). If you sell Delta at a loss, you can use that loss to offset the gain in Alpha and reduce (or eliminate) any tax you owe on ordinary income. Of course, now you’ve sold Delta at a loss which means you sold low and if that stock gains you won’t recoup that value. The technique to fix this, if you want to, is to buy a similar security to stock Delta so you will still be invested in that sector or industry (or whichever criteria there was for owning Delta in the first place) and maintain a similar asset allocation. The tricky part is that the IRS says you cannot buy a “substantially identical” security for 30 days or the wash sale rule wipes out the loss deduction. It’s called a wash sale because your loss transaction and the purchase of the same, or substantially identical, security are a “wash” and the IRS won’t allow any tax benefits to come from it. The replacement security has to be similar but not the same. Stocks issued by one company are not considered substantially identical to other stocks issued by other companies. However, it becomes a little more of a gray area if you are selling out one S&P 500 Index Fund offered by brokerage A and buying into a different S&P Index Fund sold by brokerage B.

There’s also the fact that you’re resetting your cost basis in the new investment (or the highly similar but not identical Delta-like investment from the example above). That new cost basis will be lower so you will pay more capital gains later. Even if the IRS were to disallow your loss, all is not lost. The loss  would instead be added to the basis of your new, similar, replacement security. Then when you eventually sell that one, your gain will be reduced (or loss increased) on that transaction – reducing your capital gains taxes.

An important thing to keep in mind when considering this strategy is the tax rates on gains: there is a difference in the tax rates you pay depending on how long you have held the security. A short term (owned one year or less) gain is taxed at a higher rate than a long term (more than one year) gain. This can make a big difference in the results of your overall strategy.

There are definitely advantages to tax loss harvesting. But it is a technique that can take quite a bit of time and research to do right. The transaction costs can also eat into, or erase, any potential tax savings. It’s a good topic to discuss with your financial or tax advisor.

BrightDime is not a tax or  investment advisor. The information included here is educational in nature and is not a recommendation to enter into any specific securities transaction or follow any specific tax or investment strategy.