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Tax-Loss Harvesting: Growing Your Gains

 Mark Bayley

August 29, 2016

Tax-loss harvesting seems counterintuitive, with the basic idea being that you purposely sell a stock at a loss.  This is counterintuitive because why would you purposely cancel out the gain on a winning stock pick?  The answer is taxes.  You do this in order to offset the positive capital gain from the sale of a successful stock.  Nobody enjoys paying taxes and with the right tax-loss harvesting strategy, your taxes will be decreased and your returns amplified.

Basics

When you sell a capital asset that has increased in price, you have earned a capital gain.  Depending on your local tax law, capital gains are generally taxed at a lower rate than regular income, with a possible exception if the investment has been held for less than 365 days.  Tax-loss harvesting involves selling a stock with an unrealized loss in order to offset the capital gain realized from other assets in your portfolio.  The now-realized loss can then be applied against the realized gain in order to reduce your total taxable gains.  To ensure that your portfolio asset allocation does not become skewed (see my piece: Rebalancing Your Portfolio), the funds from the liquidated stock can be used to purchase a similar asset with appropriate risk-return expectations.  Tax-losses can also be carried forward indefinitely or backwards two years or can be used to offset a portion of regular income if you do not have sufficient capital gains.

Tax-Loss HarvestingComplications

There are a number of different regulatory and tax rules that an investor needs to be aware of before undertaking tax-loss harvesting and they can vary greatly country to country.

An important IRS regulation that must be taken into account is the “wash-sale rule.”  A wash sale is when you sell an asset at a loss to offset a gain and purchase a “substantially identical” asset within 30 days of the sale (before or after).  The IRS doesn’t consider this a true sale and the re-purchased stock or security will be deemed to have a cost-base equal to the new purchase price plus the original loss.

This can be avoided by waiting 31 days to repurchase the asset but that will require your funds to not be appropriately invested for 1/12 of the year.  Alternatively, you can invest in an asset that is similar, but not “substantially identical”.  For example, if you sell Bank of America stock, you can purchase Wells Fargo stock or you can sell Disney stock and buy Warner Bros.  While they will not track each other perfectly, they will provide similar exposure to market volatility for appropriate portfolio allocations.

Tax Loss Harvesting - IRS Tax Brackets

Another aspect of tax-loss harvesting that must be taken into account is your tax bracket.  It may be inappropriate to harvest your losses if you expect to be in a higher income tax bracket in the future.  Tax-loss harvesting adds value through tax deferral but by pushing the tax into the future, you may end up paying a higher rate.  This is because the replaced asset will have a lower cost base so any future gains will be taxed at your higher tax bracket instead of being offset by initial losses.  The current savings may be worth more than the additional tax though due to the effects of the time value of money.

Simple Example 

Consider the portfolio excerpt below and an investor who is in the highest marginal tax bracket, 39.6%, which corresponds to a capital gains tax rate of 20%.  It is now approaching tax season and having sold CVS Health (CVS) for a $20,000 capital gain, it is time to consider tax-loss harvesting (as all stocks were held for more than 365 days).

Tax-Loss Harvesting Portfolio

Without tax-loss harvesting:

Taxes Paid = ($20,000 x 20%) = $4,000

With tax-loss harvesting:

Based on this simple example, it would be appropriate to close out the position in Apple (AAPL) to realize a $15,000 capital loss.

Taxes Paid = ($20,000 – $15,000) * 20% = $1,000

Savings = $3,000!

The remaining funds from the sale of Apple (AAPL) stock can be used to immediately purchase shares of a similar technology company like Google (GOOGL), or the investor can wait 31 days and repurchase Apple shares (AAPL).

Tax-loss harvesting can be a complicated process but done right it can provide an additional bump to increase an investor’s returns.  Combined with compound interest, this can create significant value for investors over the course of their lifetime.

https://www.irs.com/articles/projected-us-tax-rates-2016