Tax-Loss Harvesting: How It Works, Example, and Pitfalls to Avoid

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Tax-Loss Harvesting: How It Works, Example, and Pitfalls to Avoid

What Is Tax-Loss Harvesting?

The timely sale of stocks at a loss in order to offset the amount of capital gains tax owing on the sale of other securities at a profit is known as tax-loss harvesting.

This method is most often used to reduce the amount of taxes owed on short-term capital gains, which are normally taxed at a greater rate than long-term capital gains. The strategy, however, may also be used to offset long-term capital gains.

This method may help investors protect the value of their portfolio while lowering the expense of capital gains taxes.

A federal taxpayer may deduct a maximum of $3,000 in capital gains losses in a single tax year. However, extra losses may be carried forward into subsequent tax years under Internal Revenue Service (IRS) regulations.

Key Takeaways

  • Tax-loss harvesting is a practice that allows investors to lower the overall amount of capital gains taxes owed when selling lucrative assets.
  • Selling an asset or investment at a net loss is the approach.
  • The funds may then be used to acquire a comparable asset or security, keeping the portfolio’s overall balance.
  • The investor must exercise caution not to breach the IRS regulation prohibiting the purchase of a “substantially similar” transaction within 30 days.

Understanding Tax-Loss Harvesting

Tax loss harvesting is often referred to as tax loss selling. It may be done at any time of year, but most investors wait until the end of the year to evaluate their portfolios’ yearly performance and the effect on their taxes.

Using tax-loss harvesting, an investment that has lost value may be sold in order to claim a credit against profits obtained in other assets.

Tax-loss harvesting is an important technique for many investors in order to reduce their total taxes. Although tax-loss harvesting cannot restore an investor’s former position, it may mitigate the severity of the loss. For example, a reduction in the value of Security A might be sold to offset a rise in the price of Security B, so removing Security B’s capital gains tax burden. Investors may save a lot of money by using the tax-loss harvesting approach.

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Maintaining Your Portfolio

Getting rid of a loser in a portfolio has clear benefits. However, it always throws the portfolio’s balance off.

Investors who have carefully structured portfolios replace the asset they just sold with a comparable asset after tax-loss harvesting in order to preserve the portfolio’s asset mix and predicted risk and return levels.

But be wary of purchasing the identical item that you just sold at a loss. According to IRS regulations, an investor must wait at least 30 days before acquiring an asset that is “essentially similar” to the one sold at a loss. You will lose the capacity to write off the loss if you do so. This is known as the “wash-sale rule.”

Short-term losses may only be used to offset capital gains tax on short-term profits. Long-term losses may only be used to reduce the tax on long-term capital gains.

The Wash-Sale Rule

For the average investor, the wash-sale rule is simple: avoid buying the same stock that he or she just sold at a loss for tax purposes.

The rule, however, is designed to address more esoteric strategies involving tax-loss harvesting.

A wash sale is a transaction involving the sale of one security and, within 30 days (either before or after the sale), purchasing a “substantially identical” stock or security, either directly or indirectly via a derivatives contract such as a call option. If a transaction is considered a wash-sale, it cannot be used to offset capital gains. Moreover, if wash sale rules are abused, regulators can impose fines or restrict the individual’s trading.

The Wash-Sale Rule and ETFs

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One way to avoid the wash sale rule is by using ETFs in a tax-loss harvesting strategy. Because there are now several ETFs that track the same or similar indexes, they can be used to replace one another while avoiding violating the wash sale rule.

Thus, if you sell one S&P 500 index ETF at a loss, you can buy a different S&P 500 index ETF to harvest the capital loss.

Example of Tax-Loss Harvesting

Assume an investorearns income that puts him or her into the highest capital gains tax category. For the 2021 and 2022 tax years, that means more than $445,851 if single and $501,851 if married filing jointly.

The investor sold assets and generated long-term capital gains subject to a 20% tax rate.

The following are the investor’s portfolio profits and losses, as well as their trading activities during the year:

Portfolio:

  • Mutual Fund A: $250,000 unrealized gain after 450 days of holding
  • Mutual Fund B: $130,000 unrealized loss after 635 days of holding
  • Mutual Fund C: $100,000 unrealized loss after 125 days of holding

Trading Activity:

  • Mutual Fund E: Sold for a profit of $200,000. The fund was kept for 380 days.
  • Mutual Fund F: Sold for a $150,000 profit. The fund was kept for 150 days.

The tax owed from these sales is:

  • Tax without harvesting = $40,000 + $55,500 = $95,500.

If the investor realized losses by selling mutual funds B and C, the proceeds would be used to balance the gains, and the tax owing would be:

  • (($200,000 – $130,000) x 20%) + (($150,000 – $100,000) x 37%) = $14,000 + $18,500 = $32,500

How Does Tax-Loss Harvesting Work?

Capital losses may be used to offset capital gains, therefore tax-loss harvesting takes use of this. An investor might “bank” capital losses from unproductive ventures to pay less capital gains tax on profits sold throughout the year.

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This technique entails utilizing the profits from the sale of unproductive assets to purchase investments that are relatively similar (but not “essentially identical”) and maintain the portfolio’s overall balance.

If the loss is utilized to offset capital gains taxes, an investor cannot acquire the identical investment within 30 days.

What Is a Substantially Identical Security and How Does It Affect Tax-Loss Harvesting?

To employ tax-loss harvesting, the investor must not violate the IRS’ wash sale rule.

That is, the investor cannot sell an asset at a loss and then acquire a “substantially similar” asset within 30 days of the sale. This will render the tax loss write-off ineffective.

A “essentially similar security” is one issued by the same firm (e.g., its class A shares vs. its class B shares or a convertible bond issued by the company) or a derivative contract based on the same security.

How Much Tax-Loss Harvesting Can I Use in a Year?

The maximum amount of capital losses that may be used to offset capital gains in a year is established by the IRS. Individual taxpayers may deduct up to $3,000 in short-term losses against short-term profits in any one year. Long-term capital losses are subject to the same $3,000 maximum.

Long-term losses, on the other hand, may be carried over to subsequent years. A $9,000 loss, for example, may be spread across three tax years.

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