Save Money With a Tax Loss Harvesting Strategy
Key Points
Tax loss harvesting is a portfolio management technique where we sell securities at a loss to offset capital gains recognized. We then repurchase a similar but not identical security to maintain the comparable investment exposure.
To reap the tax benefit from tax loss harvesting, we have to ensure that we follow IRS wash sale rules. The rules state you cannot purchase the same security, or what the IRS deems “substantially identical securities” within 30 days before the sale and 30 days after the sale.
Potential issues include the possibility of larger future tax bills, selling proxy securities at a gain which negates the tax loss harvest, and experiencing investment performance differences between the proxy and the original security.
When it comes to investment management, merely constructing a portfolio is not enough. Having the right mix of securities and understanding each security’s expected return, standard deviation, and correlations to each other is highly important. It’s the ongoing portfolio management, however, that truly ensures a client’s portfolio stays on track to meet their financial goals. Because taxes are often one of the largest portfolio costs over time, we look for opportunities to mitigate your tax costs.
When the capital markets correct themselves from time to time or when certain asset classes underperform, it gives Capstone an opportunity to mitigate current and/or future tax costs for our clients by implementing a tax loss harvesting strategy.
What Is Tax Loss Harvesting?
Tax loss harvesting is a portfolio management strategy where we sell securities in a client’s portfolio at a loss to offset — or harvest — capital gains recognized in the current year. If the losses recognized exceed the gains recognized, the excess losses carry forward into future years.
A well-diversified portfolio will have many asset classes that are typically uncorrelated. This means there will be times when certain asset classes have done well and others have not. The underperforming asset classes may have losses; these are the losses we harvest.This same idea applies when there are market corrections.
Even though we may sell a certain asset class due to the loss, we aren’t sitting on cash. Instead, we reinvest the proceeds in proxy positions. For instance, if our real estate fund has underperformed and is in a loss, we would sell the fund and purchase a similar fund that offers similar exposure to that asset class. However, the proxy or replacement security has to adhere to IRS wash sale rules to benefit from the tax savings.
Tax Loss Harvesting and the IRS Wash Sale Rules
IRS wash sale rules were put in place to prevent investors from selling a security at a loss and claiming the tax benefit, just to turn around and buy that same security back.
A wash sale occurs when an investor sells a security at a loss and buys back that same security or “substantially identical” security within a 60-day window. The 60-day window consists of 30 days before and 30 days after the sale. This rule also applies to other accounts an investor owns (meaning an investor cannot buy the security back in their IRA within the 30 days after the sale).
Acknowledging the 30-day window after the sale, we’ll typically hold on to the proxy positions for 31+ days and then sell it to reinvest in our original Capstone holding. There are times where we may hold on to the proxy position for a little longer due to substantial gains that have built up during the 31 days. This all depends on our specific client’s tax projection and planning.
Tax Loss Harvesting: the Good and the Bad
When executed properly, a tax loss harvesting strategy can be an effective way to grow tax savings. According to IRS tax code: For losses that exceed capital gains, not only can you apply excess losses to future years, but you can also recognize up to $3,000 of losses against ordinary income.
That being said, tax loss harvesting isn’t without potential downsides.
Selling a security at a loss means the original cost basis is higher than the current market value. When you harvest a loss and rebuy the security after 30 days, you are, in essence, resetting your cost basis. If you hold the security long term, and it grows substantially, you could be faced with an overall larger tax bill in the future.
Additionally, if the proxy security runs up in the 31 days that you’ve held it, selling it may generate some short-term capital gains that may negate the tax loss harvesting. Lastly, due to the nature of the proxy security not being substantially identical to the original security, it may not perform as well.
Tax Loss Harvesting Made Simple
There are 3 keys to a successful tax loss harvest:
Identify the appropriate proxy security to maintain similar performance metrics and risk profile.
Adhere to the IRS wash sale rules.
Maintain a holistic view to your financial planning which incorporates both investment management, tax planning, and cash flow planning.
As with any investment strategy, you’ll want to check in with your wealth management advisor to see if it’s right for you.
Disclosures:
This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.