History has proven that investment returns vary year over year, with some years generating positive returns while others yield disappointing losses. A prudent and effective tax loss harvesting strategy can accumulate tax losses in disappointing years that can offset investment gains during years where the market yields positive returns. Tax loss harvesting is the practice of selling a security that has experienced a loss and replacing it with a similar security. By harvesting the loss, investors are able to use that loss to offset any taxes on realized investment gains from other investments. Another attractive and valuable feature of tax loss harvesting is that if total losses exceed gains in a given tax year, up to $3,000 of the excess can be used to offset ordinary income. If there is still excess loss, it can be carried over to offset capital gains and ordinary income in the future. (Please note, state tax laws may differ from federal tax laws. For example, PA does not allow capital losses to offset ordinary income nor can capital losses be carried forward.)
The IRS’s Wash-Sale Rule
There are Internal Revenue Service (IRS) rules that must be complied with in order for the tax loss to accrue to an investor’s benefit. The wash sale rule is covered in IRS Publication 550: Investment Income and Expenses. Basically, the IRS’s Wash-Sale rule prohibits an investor from claiming an investment loss if an investor, within 30 days, does any of the following: buys or acquires a substantially identical security or acquires a contract or option to buy substantially identical securities. Another item to consider in conjunction with the IRS rules governing Wash-Sales is that the replacement security that an investor purchases may appreciate during the 30-day waiting period. In this case, a decision will need to be made regarding whether to keep the new investment or potentially sell and realize a short-term capital gain (that would be subject to a higher tax rate) in order to repurchase the original investment that was sold.
Markets have rallied tremendously from the depths of the financial crisis, and many investors have significant unrealized gains in their portfolios. If investors own mutual funds, net gains in the funds will be paid out before year end and result in taxable income even if the fund is not sold. We believe it is prudent for investors to analyze their investment accounts and track capital gain distributions (most are provided in November by fund companies). If they have investments currently at a loss, realizing the loss in a particular security allows you not only to offset gains already realized, but provides an opportunity to lock in gains in other investments you wish to reduce. You may also be able to offset long-term capital gain distributions flowing through mutual funds or ETFs that you own in your account. If you have a loss in a mutual fund position which is paying out a capital gain, you may want to sell it and recognize the loss before the fund’s distribution record date.
As a planning point for 2017, we believe that the timing of tax loss harvesting can be an integral component to investing and wealth management. Many investors and financial advisors wait until the end of the year to harvest losses. In a particularly volatile year, taking a more dynamic approach to tax loss harvesting considers taking losses throughout the year if/when an opportunity presents itself. These losses are then banked until they can be strategically used in the future.
There are many components that go into making the decision to implement tax loss harvesting. However, if the proper tax loss harvesting strategies are applied, there are clear tax benefits that can be valuable to growing client wealth. We recommend consulting with a financial advisor and/or accountant before pursuing these strategies.