When life gives you lemons, make lemonade – so the saying goes. Alternatively, when the market gives you losses, avoid paying taxes. Tax loss harvesting is the act of intentionally selling an investment at a loss to offset current and/or future capital gains. If executed properly, it is a powerful technique used to significantly lower one’s taxable income and hence taxes.
Taxes come in many shiny packages (income, sales, capital gains, property, estate, etc.), and while some are hard to avoid, others can be easily minimized. Many of us have made tax deductible donations throughout the year to help our favorite charities and lower our taxable income, but only a few harvest losses.
Today’s losses can offset future gains
Of course everyone prefers to see their stock portfolios rise in value, even if that means having to pay tax on capital gains. But as we have painfully witnessed in recent years, portfolios can also incur losses. While no one likes to see their investments go down in value, savvy investors can capitalize on such losses and make lemonade out of their lemons.
Current IRS rules limit capital loss deductions to only $3,000; the good news is that losses greater than $3,000 can be carried over and used in future years. For example, assume you purchased an investment for $20,000 and sold it for $10,000. You can only deduct $3,000 each year from your taxable income. The remaining $7,000 would carry over to future years to offset future capital gains. So if the following year you sold another investment for a $15,000 capital gain, you would pay tax on only $8,000 ($15,000 – $7,000). Tax loss harvesting is when you intentionally sell an asset (even if you still like the asset) to recognize and bank (harvest) the loss for future use. Here is how it works.
How tax loss harvesting works
Assume you bought investments in 2021 worth $100,000. Now, they’re worth $60,000. You initially purchased the investments for long term growth and have no intention of selling them, because the investment still helps meet your long term goals. While you have a 40 percent loss, the loss is unrecognized because you have not sold anything. By harvesting your losses, you would sell your investments now, realize a $40,000 loss which you can save to offset future capital gains, and repurchase your investments.
Your investments would still be worth $60,000, but now you have “lemonade” you can drink for years to come. You are still only limited to $3,000 per year in losses as discussed above, but now you have $40,000 in losses you can save and use to off-set any future capital gains for multiple years. These losses only expire upon your death.
Let’s assume you had no other sales for the next few years, but continue to deduct the $3,000 allowed per year. After 5 years, you sell a rental property for a $50,000 gain, but you still have $25,000 of unused losses (original $40,000 less $15,000 (5 years at $3k/year). You can use the $25,000 unused loss to off-set that gain and only pay tax on $25,000. This will substantially decrease your taxes.
Limitations of tax loss harvesting
As with everything, the IRS has rules and limitations. The IRS wash-sale rule stipulates that if you sell an investment to recognize a loss, you cannot buy another “substantially identical security” within 30 days.
So for instance, if you sold State Street S&P 500 SPDRs (ticker: SPY), you cannot replace it with the iShares S&P 500 Index (ticker: IVV) because they both own essentially the same investments. However, you can purchase a temporary investment that is not essentially the same, but is highly correlated. Using the same example, you could sell the SPY to recognize a loss and purchase the iShares Russell 1000 Value Index (ticker: IWD) as its replacement. The two assets are not essentially the same, but they are both highly correlated and tend to move in tandem.
No one likes to lose money on their investments, but when the markets are volatile, give yourself the gift that keeps on giving for years to come – harvest your losses. If done properly, you could avoid paying taxes on capital gains for years. Please be aware that tax loss harvesting is only relevant in your taxable accounts, and not in your IRAs, 401ks, or other retirement accounts. Each person’s tax situation is different so investors should consult with their financial and tax advisors.
Looking for an independent fiduciary financial advisor who can advise you on investments, retirement, real estate, alternative assets, and taxes? Contact ACap Advisors & Accountants to schedule a free initial consultation. Our clients include individuals, small businesses, entrepreneurs, and anyone serious about saving and investing for their future.
