By: Robert Gordon
By: Robert J. Gordon, MBA, CFP®, AIF®
Market downturns are no fun but for the long term investor with taxable accounts and a solid investment management plan, they present the opportunity to pocket losses which can be used to offset future gains. The process of pocketing those losses is generally referred to as ‘Tax Loss Harvesting.’
What is Tax Loss Harvesting?
The tax code permits investors to sell securities in which they have a loss and use that loss to offset gains generated immediately or in the future on other securities. Typically, the paper or unrealized losses are shown on the investor’s account statement. Once the investor sells or closes the losing position, the dollar amount of the loss and all details related to the loss (or gains for that matter) are listed in the statement as realized gain/loss. The information on this report is used for filing your federal and state income taxes. Capital gains and losses fall into two categories: short term and long term. Short term gains/losses apply to investments held for one year or less and long term gains/losses apply to everything else. Today, the tax rate on long term gains is 15% and the short term gains tax rate is the same as your ordinary income tax rate which may be as high as 35% (this applies to all but those in the very lowest tax bracket who may have no capital gains tax exposure.) Clearly, investors with gains would prefer that they be long term gains. Better still would be to offset the gain altogether with losses that were experienced in prior years. That is where tax loss harvesting steps onto the stage.
Tax Loss Harvesting In Action
The process of deciding which securities to harvest is contingent upon your cost accounting method. Without getting too technical, the finer the detail you can use in identifying when specific securities were purchased, the more productive will be your harvesting efforts. Some investors keep records of the date of purchase for specific lots. This means that not only is the date and price of the initial investment recorded and divulged but the same applies to all subsequent purchases of the same security.
By way of example, I’ve shown below the purchase of three separate lots (frequently referred to as tax lots) of the Fictitious Fund (symbol ABCDX.) The Fictitious Fund is a nonexistent U.S. Large Capitalization Value Index fund (any similarity to a real fund is unintended and coincidental.)
|Purchase Date||Symbol||Share Quantity||Price Per Share||Total Cost|
Let’s assume that on December 20, 2010, the fund company announces that all shareholders will be receiving a $5.00 per share capital gains distribution (all short term) and the share price now sits at $80.00. If you simply hold onto these shares through the end of the year, you will receive a taxable capital gains distribution of $1,250 which, for a person in the 25% marginal tax bracket, will trigger a $312.50 tax liability. You have an unrealized loss on the shares purchased on August 18 and October 12 only. To offset the $1,250 ($5 per share times 250 shares) short term capital gains distribution the fund company is about to send you, you decide to realize the loss on just those two lots (which is $5,500.) Not only have you completely offset the short term gain on which you would have paid taxes at your highest marginal income tax bracket, you have realized losses that can be used to offset future gains. To be precise, you have created $4,250 in losses that will get carried forward from year to year until they are exhausted. This is called a capital loss carryover.
Navigating The Rules
The IRS allows investors to essentially ‘pocket’ investment losses for use in the future against investment gains – the capital loss carryover. Those losses are accumulated on Schedule D of the Form 1040. You can completely offset capital gains using these losses or, if there are not sufficient gains after netting in any given year, taxpayers can apply up to $3,000 of the losses to offset taxable ordinary income. You are probably thinking, “What about my longer term objective of maintaining exposure to this important asset class?” You can’t just sell the position and buy the exact same security the next day. The rule that governs how you replace that exposure is called the wash sale rule. Essentially it says that if you buy back the same or a substantially similar security 30 or fewer days after selling the losing security, your losses are basically disallowed. The actual period is 30 days before to 30 days after the date of the sale. With the proliferation of exchange-traded funds (ETF) and index mutual funds, index-oriented investors have multiple options for replacing the harvested securities without running afoul of this rule. Care is required though since some ETFs and index mutual funds could be considered ‘substantially identical’ securities. If we apply this to the taxpayer in our example, they might choose to purchase iShare’s Russell 1000 Value Index Fund (symbol IWD,) which is an ETF, to replace ABCDX.
Investors should review their portfolio’s tax efficiency on a periodic basis to ensure that they are taking full advantage of all available opportunities to improve after-tax performance. Judge Learned Hand who served on the U.S. Court of Appeals for many years summarizes the taxpayer’s responsibilities in this famous quote:
Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister
in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.1
1 Judge Learned Hand comments in Gregory v. Helvering 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935)
NOTE: This article is intended to give general information only and cannot be relied upon for investment or tax advice. Please consult your tax or investment professional for specific counsel.