Maybe it isn’t harvest time in the traditional, farming sense, but it’s getting close to tax loss harvest time. This is only for those of you that have stocks, mutual funds or exchange traded funds (ETFs) in taxable accounts (outside of retirement accounts). Those of you that have been learning about managing your investments know that you, generally, want to sell high and buy low. Life is messy and that goes doubly for our U.S. tax code. This is an exception to the rule. I’m also, generally, against active trading, so why would I encourage you to sell something instead of sticking with buy and hold with occasional rebalancing? Well, this is an exception to that rule too. I’m going to briefly explain two of the situations where you should consider doing this.
The first situation is when you are simply trying to, legally, lower your tax bill for the current year. If one of your investments is showing a loss on paper, sell it. At least sell enough of it that you have a $3000 loss. Although you can carry over capital losses to future years, you can only use $3000 per year: unless you have other capital gains with which to offset these losses. Understand that this won’t lower your tax bill by $3000: it will lower your taxable income by $3000. If you’re in the 35% tax bracket, you’ll save up to $1,050 in tax. If you’re in the 28% tax bracket, you’ll save up to $840 in tax. You get the idea: multiply the appropriate tax percentage by $3,000 (or the actual number if the loss is lower).
The second situation is when you have sold other assets and you have a capital gain that you’re trying to offset. In this situation, your potential tax savings are much higher. If you have a $10,000 capital gain, and you have a stock, ETF or mutual fund that is currently showing a loss of $10,000, you can sell that security to totally offset the capital gain. If you have the same situation but you have a security that shows a larger loss, you can realize the loss (sell it), offset the entire $10,000 capital gain and still take the rest of the loss, up to $3,000 for that year with the rest carried over. This can get a little complicated if you have sold several items at either short or long-term capital gains or losses. You offset the long-term gains with long-term losses and then short-term gains with short-term losses, then you net the long-term with the short-term. However, if you only have a long-term gain and only a short-term loss those will directly offset the other.
What are a few of the complications or drawbacks to doing this?
First, you’re selling out of a position or partially out of a position in which you were advised to invest. Yes and No. As long as you do not replace that security 30 days before or after the sale with a substantially similar security (and that phrase can trip you up), you’re fine. So you could take a loss and rebuy that same security more than 30 days later. The drawback is that you could miss out on dividends and an increase in the price while you don’t own it. You may repurchase it and end up with a lower basis, however the new basis could be higher too. If you find yourself in a higher than normal tax bracket, this move might well be worth the trouble for you.
Second, there’s the time, trouble and, less significantly, the added commission expense for doing the trades. Don’t mess with it if the loss isn’t large enough to save you money after the trades and, possible, added expense with tax preparation are added back in.
As always, this is intended to be educational. Consult your financial advisor or tax person to see if these types of actions would be appropriate for your situation.
