Mar 23, 2023
Tax-Smart Strategies: Can You Take Advantage of Tax-Loss Harvesting?
Tax-loss harvesting makes it possible to turn paper losses into real, deductible losses for tax purposes. In this part of our series on tax-smart strategies, we will look at whether this could be the right move for you.
Tax-loss harvesting, which is also known as tax-loss selling, is a strategy that investors use to show a loss on one investment in order to claim a credit against the profits that were realized from another investment.1
Here’s a hypothetical example:
Imagine that you had the foresight to buy 100 shares of Facebook back in 2016 for $100 per share, and you sold it at $300 per share in 2022. Great trade, but since you just made a $20,000 profit, you could have a capital gains tax bill coming due.
Now imagine that you had also purchased $100,000 worth of an ETF in 2021 and that it declined in value by 20% during 2022. This ETF may be a long-term investment that you intend to hold indefinitely, but this is where tax-loss harvesting comes in.
At the end of 2022, you could have sold the ETF in order to realize a loss of $20,000, which you could use to offset your $20,000 taxable gain on Facebook. Then, about a month later, you could buy the same or a similar ETF to restore the original composition of your portfolio.
Maximize your tax-loss harvesting
The ability to reduce or erase realized gains is nice, but there are a number of items that we believe are important to keep in mind in order to execute this strategy properly:
- Carefully calculate your gains and losses. When you sell an investment, the difference between the adjusted basis and the amount you realized from the sale is a capital gain or a capital loss. If your losses outweigh your gains, you may be able to apply some of the excess to further reduce your income, or you will have to carry it forward to future years.2
- Avoid the Wash Sale Rule. When performing tax-loss harvesting, you will need to wait at least 31 days before buying back the original position or a substantially similar investment. This is to avoid the Wash Sale Rule, which would nullify the original tax loss and defeat the purpose of this strategy. If you wish to remain invested while you wait for this period to pass, it may be helpful to talk to your advisor about different security allocation strategies that could provide similar returns without falling under the Wash Sale Rule. In addition to this, the IRS has a complete guide on Wash Sale Rules here: https://www.irs.gov/publications/p550#en_US_2021_publink100010601
- Work with your advisors. Virtually every tax strategy involves some complexity, and tax-loss harvesting is no exception. Not only must you play within the bounds of the tax rules, but you may also wish to be strategic about the amount and timing of your gains and losses, security selection and portfolio construction. For this reason, we believe it is essential to consult your wealth and tax advisors for assistance.
Tax-loss harvesting can be a useful tool for reducing overall taxes. In many cases, a loss in the value of Security A can be realized to offset the capital gains tax liability of Security B. Speak with your advisor about whether this strategy makes sense for you.
1 https://www.investopedia.com/terms/t/taxgainlossharvesting.asp
2 https://www.irs.gov/taxtopics/tc409#:~:text=Topic%20No.%20409%20Capital%20Gains%20and%20Losses.%20Almost,is%20a%20capital%20gain%20or%20a%20capital%20loss
ABOUT THE AUTHOR
Matt Foltz, CPA, CFP, CEPA, MS in Accountancy
Matt sits on BDF's Financial Planning Committee and leads many of the firm's tax-related initiatives. He has a passion for building strong relationships with his clients and helping them make sound decisions. Matt also holds the Certified Exit Planning Advisor designation which helps him advise business owners on how to exit their business and prepare for retirement.
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