Tax-Loss Harvesting

What Is Tax-Loss Harvesting?

Tax-loss harvesting is the opportune selling of securities at a loss to offset the amount of capital gains tax due on the sale of different securities at a profit.

This strategy is most frequently used to limit the amount of taxes due on short-term capital gains, which are generally taxed at a higher rate than long-term capital gains. Notwithstanding, the method may likewise offset long-term capital gains.

This strategy can assist with protecting the value of the investor's portfolio while diminishing the cost of capital gains taxes.

There is a $3,000 limit on the amount of capital gains losses that a federal taxpayer can deduct in a single tax year. Be that as it may, Internal Revenue Service (IRS) rules permit extra losses to be carried forward into the accompanying tax years.

Understanding Tax-Loss Harvesting

Tax-loss harvesting is otherwise called tax-loss selling. It tends to be finished whenever of the year, yet most investors hold on for the rest of the year when they evaluate the annual performance of their portfolios and its impact on their taxes.

Utilizing tax-loss harvesting, an investment that shows a loss in value can be sold to claim a credit against the profits that were realized in different investments.

For some investors, tax-loss harvesting is a critical device for lessening their overall taxes. Despite the fact that tax-loss harvesting can't reestablish an investor to their previous position, it can reduce the seriousness of the loss. For instance, a loss in the value of Security A could be sold to offset the increase in the price of Security B, in this manner dispensing with the capital gains tax liability of Security B. Utilizing the tax-loss harvesting strategy, investors can understand critical tax savings.

Keeping up with Your Portfolio

Unloading a loser in a portfolio clearly enjoys benefits. In any case, it unavoidably upsets the balance of the portfolio.

After tax-loss harvesting, investors who have carefully built portfolios supplant the asset they just sold with a comparative asset to keep up with the portfolio's asset mix and expected risk and return levels.

Beware, however, of buying the very asset that you just sold at a loss. IRS rules expect that an investor waits for something like 30 days before purchasing an asset that is "substantially indistinguishable" to the asset that was sold at a loss. Assuming you do as such, you lose the ability to write off the loss. This is the feared "wash-sale rule."

Short-term losses must be utilized to offset short-term capital gains tax. Long-term losses must be utilized to offset long-term capital gains tax.

The Wash-Sale Rule

The wash-sale rule is straightforward for the average investor, who simply needs to try not to buy a similar stock the person just sold at a loss for tax purposes.

The rule, nonetheless, is intended to address more esoteric strategies including tax-loss harvesting.

A wash sale is a transaction including the sale of one security and, in no less than 30 days (either before or after the sale), purchasing a "substantially identical" stock or security, either straightforwardly or in a roundabout way through a derivatives contract, for example, a call option. On the off chance that a transaction is viewed as a wash-sale, counterbalancing capital gains can't be utilized. In addition, on the off chance that wash sale rules are mishandled, regulators can impose fines or confine the individual's trading.

The Wash-Sale Rule and ETFs

One method for keeping away from the wash sale rule is by involving ETFs in a tax-loss harvesting strategy. Since there are presently several ETFs that track something similar or comparable indexes, they can be utilized to supplant each other while trying not to disregard the wash sale rule.

Consequently, in the event that you sell one S&P 500 index ETF at a loss, you can buy an alternate S&P 500 index ETF to harvest the capital loss.

Numerous roboadvisors offer free tax-loss harvesting in a way that is automated and won't disregard the wash-sale rule.

Illustration of Tax-Loss Harvesting

Expect an investor procures income that puts the person in question into the highest capital gains tax category. For the 2021 and 2022 tax years, that means more than $445,851 if single and $501,851 whenever married filing jointly.

The investor sold investments and realized long-term capital gains, which are subject to a tax rate of 20%.

Below are the investor's portfolio gains and losses and trading activity for the year:

Portfolio:

• Mutual Fund A: $250,000 unrealized gain, held for 450 days
• Mutual Fund B: $130,000 unrealized loss, held for 635 days
• Mutual Fund C: $100,000 unrealized loss, held for 125 days

Trading Activity:

• Mutual Fund E: Sold, realized a gain of $200,000. Fund was held for 380 days
• Mutual Fund F: Sold, realized a gain of $150,000. Fund was held for 150 days

The tax owed from these sales is:

• Tax without harvesting = ($200,000 x 20%) + ($150,000 x 37%) = $40,000 + $55,500 = $95,500

In the event that the investor harvested losses by selling mutual funds B and C, the sales would assist with offsetting the gains and the tax owed would be:

• Tax with harvesting = (($200,000 - $130,000) x 20%) + (($150,000 - $100,000) x 37%) = $14,000 + $18,500 = $32,500

Features

• The strategy includes selling an asset or security at a net loss.
• Tax-loss harvesting is a strategy investors can use to reduce the total amount of capital gains taxes due from the sale of profitable investments.
• The investor can then utilize the proceeds to purchase a comparable asset or security, keeping up with the portfolio's overall balance.
• The investor must be careful not to disregard the IRS rule against buying a "substantially indistinguishable" investment in 30 days or less.

FAQ

What Is a Substantially Identical Security and How Does It Affect Tax-Loss Harvesting?

To utilize tax-loss harvesting, the investor can't disregard the IRS' wash sale rule.That is, the investor can't sell an asset at a loss and buy a "substantially indistinguishable" asset inside the 30-day period before or after that sale. Doing so will negate the tax loss write-off.A "substantially indistinguishable security" is defined as a security issued by a similar company (for example its class A shares versus its class B shares or a convertible bond issued by the company), or a derivative contract issued on a similar security.

The amount Tax-Loss Harvesting Can I Use in a Year?

The IRS limits the maximum amount of capital losses that can be utilized to offset capital gains in a year. An individual taxpayer can write off up to $3,000 in a given year in short-term losses against short-term gains. The equivalent $3,000 cap applies to long-term capital losses.Long-term losses, notwithstanding, can be carried forward to future years. For instance, a $9,000 loss can be spread north of three tax years.

How Does Tax-Loss Harvesting Work?

Tax-loss harvesting exploits the way that capital losses can be utilized to offset capital gains. An investor can "bank" capital losses from unprofitable investments to pay less capital gains tax on profitable investments sold during the year.This strategy incorporates utilizing the proceeds of selling the unprofitable investments to buy fairly comparable (yet not "substantially indistinguishable") investments that protect the portfolio's overall balance.IRS rules preclude an investor from buying similar investment in something like 30 days assuming the loss is utilized to offset capital gains taxes.