Why your losses aren’t lost.
Investing for the long term means accepting that some of your investments may go down in value at times. If you buy a mutual fund for $30/share, and it’s price drops to $25/share, you have what is known as an unrealized loss (assuming you still own it). Many investors assume such losses may be temporary, and hold those shares in expectation that the price will rise. When the price does go up – say, to $35/share – you have what’s known as an unrealized gain.
These unrealized losses and gains are oftern called “paper losses” or “paper gains”. Until you sell your shares, and realize the loss or gain, this is true. But what if you sell the shares, and realize the loss, or the gain? Unless your account is a retirement account, these gains or losses result in a tax, or a tax deduction.
While portfolio losses are never ideal, those losses aren’t necessary losses when taking your entire portfolio into consideration. This article explores an investing technique called “tax loss harvesting”: when it makes sense, and the shortcomings that one should be aware of when considering tax loss harvesting in their portfolios.
What is tax loss harvesting? This means an investor intentionally sells an investment at a loss to realize losses for tax planning purposes. Realized capital losses can generally offset ordinary income by $3,000 per year, or to offset capital gains that are realized in the same tax year. Realized losses that are not all used to offset realized capital gains may be carried forward to future years. Each year, $3,000 is used to offset ordinary income if you have unused capital losses from prior years.
Short-term and long-term losses can both be harvested, but it is important to remember that short-term losses first net against short-term gains, and long-term gains net against long-term losses. Short-term refers to investments held under a year.
What are some advantages of tax loss harvesting?
Tax loss harvesting provides several benefits, some immediate, and others can provide longer term benefits. For example, being able to deduct $3,000 from your taxable income has an immediate tax savings benefit. For long-term benefits, this technique can allow investments with large capital gains to be offset with capital losses. This can be taken immediately by selling the highly appreciated asset, and then buying it back immediately to reset your cost basis. Or, the benefit can be used in the future with losses carried forward.
This technique comes with pitfalls, as well.
Mistakes can be costly. Before considering this technique, consult your tax or financial advisor to be sure you are following IRS rules and understand how to properly implement the technique. Some investments in your portfolio may have been purchased on different dates, for widely different prices: you must make sure to sell only the “tax lots” which provide the loss or gain you need. It is also very important to comply with the “wash sale rule”, which disallows the purchase of the same or a “substantially identical” investment 30 days before or after the sale that realized the loss. And, when preparing your tax return, it’s important to properly report your realized short- and long-term gains and losses, which are reported on your Form 1099 from your investment accounts, as well as to properly report any carry-forward losses from prior years.
Finally, a reality check is important.
Before considering tax loss harvesting, consider if the tax benefit is worth the time and cost of the transaction, and if this makes good investing sense. Like so many aspects of financial planning, this technique should fit into the big picture of your unique plan. And, again, consult a professional who is highly knowledgeable in tax and financial planning before implementing this or other tax-related strategies.
If you are interested in speaking with a financial advisor, follow this link to schedule time to talk to an advisor.
Jack O’Brien CIMA® is a Certified Investment Management Analyst educated at Chicago Booth School of Busisness and Virginia Tech. EVOadvisers is a fee-only financial advisor based in the Scott’s Addition area of Richmond, Virginia. EVOadvisers also has an office in Irvington, Virginia to better serve clients in the Northern Neck of Virginia. If you have any questions about financial planning and would like to talk with one of our Certified Financial Planner professionals, check us out at www.evoadvisers.com or call (804)794-1981.
Reference: IRS Publication 550 (2022), Investment Income and Expenses