Making Lemonade from Lemons: Tax Loss Harvesting
When life gives you lemons, make lemonade. That is the idea behind tax-loss harvesting, a phrase used to describe various ways that investment losses can be used to offset investment gains. Nobody likes to take losses on their investments, but sometimes it makes financial sense to do so. This is because the U.S. tax code provides forms of financial relief when taking a loss, and this relief, when managed prudently, can shelter taxable gains and income to maximize returns overall. Though the phrase “harvesting” makes us all think of the fall season, and while tax-loss harvesting is often considered to be a fall activity (like pumpkin harvesting), it is important to recognize that the strategies outlined below can be used throughout the year. Really, tax-loss harvesting is tied to investment volatility, which can happen at any time and is not dependent on the calendar or the cycles of the moon.
First, some definitions are in order. The IRS distinguishes between realized gains or losses and unrealized gains or losses. Realized gains or losses become “real” so to speak only when an investment is actually sold. The selling price and date, relative to the purchase price and date, determine the size and duration, respectively, of the gain or loss. Up until an investment is sold, its gain or loss is considered to be unrealized. In other words, it remains a “paper” gain or loss. An investment’s unrealized gain or loss is continually changing, fluctuating up and down with the market. An investment’s realized gain or loss is locked in and permanent.
The IRS further distinguishes between short-term gains or losses and long-term gains or losses. The government wants to get its slice of the pie, but it also wants to reward long-term investment and disincentivize short-term speculation. Therefore, gains on investments held for one year or less are considered to be “short term” and are taxed at an investor’s marginal tax rate, which is usually high. Gains on investments held for more than one year are considered to be “long term” and are taxed at a more favorable capital gains rate, which can range from 0% to 20%.
These distinctions are important because they have implications for tax-loss harvesting. In short, the rules say that realized losses can be used to offset realized gains. However, short-term losses must first be used to offset short-term gains, and long-term losses must first be used to offset long-term gains. After an investor has offset all of his or her short-term gains with short-term losses, he or she can apply any remaining short-term losses to long-term gains, and vice versa. To the extent an investor has more total losses than total gains, he or she can use those losses to offset up to $3,000 of ordinary taxable income. Finally, to the extent an investor has such significant losses that those losses exceed the sum of any realized gains plus the $3,000 ordinary income offset, the remainder can be carried-forward into future years to offset taxable gains and income down the road.
Let’s look at an example. To keep things simple, we will ignore any distinction between short-term and long-term gains or losses. This example is for illustration purposes only and should not be construed as investment advice or tax advice. Each individual’s situation is unique, and an investor should always consult with his or her tax preparer and financial advisor before undertaking any tax-loss strategy.
It has been a good year for Jane. She sold a number of stocks for more than she paid, and she now has $40,000 in realized capital gains. Unfortunately, unless she does something, Jane will be taxed on these gains. Jane’s advisor, Loretta, suggests that Jane sell shares of Sadface Corporation, which is currently trading for less than Jane paid. This would result in a realized capital loss of $25,000, which would reduce Jane’s overall taxable gains to $15,000 for the year and save Jane approximately $3,750 in federal income taxes, assuming a 15% long-term capital gains rate.
“But why would I sell Sadface?” asks Jane. “The outlook is positive even though the stock is down.”
“Correct,” replies Loretta. “However, I don’t expect Sadface to recover until sometime toward the end of next quarter, at which time it is expected to be acquired by Happyface Corporation. We can sell the stock now, realize the loss for tax purposes, and repurchase it again in 31 days. Repurchasing the stock will not invalidate the tax benefits of the loss, so long as we wait 30 days between the date of the sale and the date of the repurchase.”
“What should we do with the proceeds from the Sadface sale over the next 31 days?” Jane inquires.
“You have a few choices,” Loretta says. “First, you could keep the proceeds in cash or a short-term fixed income vehicle. Second, you could purchase an index fund that tracks either the broad stock market or a subset of the stock market. Third, you could purchase a different company in the same industry. Each of these choices has its own pros and cons. If none of these choices is suitable, then a fourth choice would be to forego the sale today. Instead, you could double up on your position in Sadface Corp., wait 30 days, and then sell one-half of your doubled-up position on day 31.”
There is a lot to unpack in this example, and, as Loretta says, there are pros and cons to various approaches. To begin, Loretta mentions a 30-day rule. This rule, called the wash sale rule, is designed to prevent investors from skirting the intent of tax laws. If one could simply sell a stock, immediately buy it back, and still use the loss to offset gains, then this would be rather unfair. Such an investor would never actually exit the position, for all intents and purposes, and yet he or she would get a tax benefit from the loss. The IRS makes a 30-day distinction to ensure that investors must fully exit from an investment before they can claim a realized capital loss. If, within 30 days, an investor were to repurchase the same investment (or purchase a substantially identical investment or a contract or option to do so), then the loss would be invalidated for tax purposes. Note – the loss would not be invalidated on the investor’s brokerage statement. It would still be a financial loss! The wash sale also applies if an investor sells a security and that same security (or a substantially identical security) is purchased within 30 days by the investor’s spouse or a company controlled by the investor.
Of course, this rule has implications. In the foregoing example, what would happen if Loretta were to be wrong and Sadface stock were to recover before the 30 days are over? Loretta is making a big assumption that Jane will be able to exit the stock and reenter without financial harm. However, if Sadface were to recover before Jane can repurchase, then Jane will have missed out on the gain, and she will have effectively locked in a permanent loss. Given that the magnitude of the $25,000 loss exceeds any financial benefit from offsetting taxes on the gains, Jane would be worse off.
Knowing this, Loretta has given Jane a series of choices for reinvesting her money over the next 30 days, from short-term fixed income, to an equity index fund, to a replacement stock. It is important to note that, by definition, none of these are substantially identical to Sadface stock, and therefore none of them are perfect substitutes. If, for example, Jane were to purchase a broad index fund, Sadface stock could go up and the index fund could go down – a double whammy! Or, Sadface could stay flat and the index could go up significantly. While this wouldn’t be the worst case scenario, it would require Jane to realize a short-term taxable gain on the index fund, adding to her tax challenges, before she would have proceeds to repurchase Sadface stock.
Although investors need to be mindful of the substantially identical standard, this doesn’t mean the replacement security needs to be wholly unrelated to the security that was sold. For example, let’s say an investor were to sell shares of Exxon Mobil at a loss. Rather than purchase the SPDR S&P 500 Index Fund (SPY), which tracks a broad basket of 500 U.S. stocks, an investor might instead purchase the Energy Select Sector SPDR Fund (XLE), which is focused solely on the energy sector. XLE and Exxon Mobil are more closely correlated than SPY and Exxon Mobil, and they are more likely to move in the same general direction over the same general time period. Alternatively, one might purchase a close competitor, like Chevron. This, however, comes with added risk. Because Chevron is one company and not a diversified basket of companies, an investor in this situation would want to be sure she understands the risks specific to Chevron, just as must as she understands the risks specific to Exxon.
Lastly, Loretta says that Jane could forgo selling Sadface stock today and instead “double up” (sometimes called “doubling down”). Rather than sell the stock now and wait to buy it back, Jane could instead double her position in Sadface stock today and then wait until day 31 to sell whichever Sadface lot is in the biggest loss position (her original shares or her newly acquired shares). In this situation, Jane would have no need for a replacement, because she would remain invested in Sadface stock throughout the wash sale period. Such is the primary benefit of this strategy as opposed to the other choices. The downside is that Jane would be overweight Sadface stock for 30 days, which has its own potential for trouble. For example, what if Sadface stock were to rally significantly over the 30 days? Jane might no longer be in a loss position across any of her lots, and she would instead hold an overweight position – half of which is in a short-term gain! In addition, Jane might not have enough liquidity to purchase an entire second position of Sadface and undertake the double up strategy. To fund the equivalent of a second position with minimal cash outlay, Jane could consider purchasing a call option on Sadface stock rather than Sadface stock directly.
Clearly there is a lot to consider. Because the future is uncertain, one cannot know in advance whether it will be best to undertake tax-loss harvesting – and how. Therefore, an investor should always consult a qualified professional and keep the following rules of thumb in mind:
First, the degree to which it is worthwhile to harvest losses depends on an investor’s tax situation. Investors who are in high tax brackets are more likely to benefit from tax loss harvesting, because each dollar of losses amounts to more pennies saved in taxes. Because tax-loss harvesting, in some ways, is akin to market timing, investors with little to benefit, such as those investors in the 0% capital gains tax bracket, should reconsider whether the tax benefits outweigh the timing risks.
Second, an investor looking to harvest losses should never assume she will be able to repurchase a liquidated position (or sell a doubled-up position) at the same price 31 days later. Markets are volatile, and prices change. Before trading an investment for tax purposes, an investor must first ask herself, “Am I comfortable selling (buying) this investment at this price and NEVER repurchasing (selling) it?” If the answer is “no,” then that investor should reconsider. At the end of the day, a sale is a sale, a buy is a buy, and the future is uncertain.
Third, an investor should pay attention to tax lots. Sometimes, an investor will hold shares of stock that are in a gain position overall. However, perhaps that investor purchased the shares in fits and starts over the course of many years. It may be that some of the lots are in a loss position while others are in a gain position. There is no rule that an investor must sell all or none of his holdings. Rather, an investor can choose which lots to sell and which lots to keep, selling only those lots that are the most advantageous from a tax perspective.
There are many intricacies to tax-loss harvesting, and we have only started to scratch the surface. As always, an investor should consult their CPA or tax preparer before engaging in any tax-loss harvesting strategy. A tax specialist can help to determine the degree to which losses need to be harvested, if at all, and they can help to keep track of carryforward losses from prior tax years. In addition, a tax specialist can determine what might be owed at the end of the year and what should be paid throughout the year in the form of quarterly tax estimates.
Before we close, and as somewhat of an aside, investors should always consider the opportunity cost of remaining in a poorly performing investment. Loss aversion bias is the tendency for investors to feel the emotional pain of financial loss more acutely than the joy from financial gain. This bias can make us hold onto a losing position, even if that position has no potential for recovery, simply because we cannot bear to let it go without breaking even. In such cases, it is helpful to remember that a hold is not much different from a buy. If an investor is holding a loser, and if that loser has no hope of retracing its prior peaks, then the opportunity cost of maintaining that position is equal to the return that could be generated on any other better investment. In such cases, it is almost always best to cut one’s losses, take whatever meager proceeds might be left, and put those proceeds to better work elsewhere. If the sale takes place in a taxable account, then at least the loss can be put to good use. However, even if the sale takes place in a tax-deferred or tax-exempt account, lemonade can still be made from those lemons – in the form of reduced opportunity cost.
As always, we are happy to answer any questions you might have about tax-loss harvesting or any other topic.