When the stock market experiences volatility, fear is often a resulting emotion.  Fear can lead an individual to do irrational things, one of which is selling at a loss.  From a long term investing perspective, selling in a down market is seen as a losing move, however there is one silver lining to selling stocks for a loss, and in fact it is a strategy that can garner considerable gain out of loss. Enter tax loss harvesting. 

What is Tax Loss Harvesting?

With tax loss harvesting (TLH) the concept is simple - sell your investments at a loss to reduce your tax liability.  In the realm of tax loss harvesting you can “harvest” your losses and utilize them to:


  • (1) Offset gains on investments


  • (2) Offset up to $3000 in non-investment income (or $1500 if married filing separately)

How Does Tax Loss Harvesting Work?

Tax loss harvesting can only be used with investments that are subject to capital gains tax.  This means your IRA and 401(k) will be off limits. This strategy can be a bit complicated if done manually, but luckily many brokerages offer TLH as a “feature” with their platform.  We always recommend consulting with your CPA or other tax professional before beginning the process, especially if it is your first time. (Need a CPA/tax professional? Check out our vetted recommendations)


There must be a catch...what is the Wash-Sale Rule?

What is the Wash-Sale Rule?

In an effort to mitigate excessive tax loss harvesting benefits, the IRS implemented the Wash-Sale Rule which states that the loss on a sale of a security will not be allowed if the same or substantially identical security is then bought within 30 days.  This definition includes securities bought before or after the sale of security that has a loss.


The simple way around this?  Make sure to wait at least 31 days before and after your tax loss harvest sale before buying the identical or very similar security.


Note: Keep in mind that the calendar years do not play any role in alleviating the Wash-Sale Rule, so transactions done at the end of the year still need to follow the rule.


Ok, this is making sense, now give me a real world example!

 

Real World Example

Let’s say you purchase the ABC fund for $10,000, but it’s now worth only $7,000. You could sell the holdings and take a $3,000 loss (max)


You are required to wait 30 days before repurchasing another fund (wash-sale rule) 


Then on Day 31, you could use the $7000 proceeds to purchase shares of XYZ fund (similar, but not substantially identical fund) after determining that it is as good as or better than the ABC fund.


You could then use the $3,000 capital loss from ABC Fund to offset some of your taxable income for the current year. If your combined marginal tax rate is 30%, you could receive a current income tax benefit of up to $900 ($3,000 × 30% = $900). You could then turn around and invest these tax savings back in the market.

 

Conclusion

Tax loss harvesting is a great way to turn a less-than-stellar situation into a more positive one.  Utilizing TLH to maximize gains is complicated, and as is the case with stocks/ETFs, there is always a certain amount of uncertainty.  If you truly want to play the TLH game to maximize gains, make sure to get a professional involved and do extensive research. However, if you have already sold in the down market for a loss, or are looking to unload securities you no longer deem valuable, consider using the advantage of reporting losses to offset capital gains or non-investment income on your next tax return.

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About Dr. Aaron Neufeld

Dr. Aaron Neufeld is a Co-Founder and editor for ODs on Finance. He owns a group private practice in Los Altos, CA and values a debt-free lifestyle as well as serial investing in real estate and index funds. Contact him: aneufeldod@gmail.com

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