Tax-loss harvesting is a technique often used by investors to use realized losses on some of their investments to offset investment gains or ordinary income. Tax-loss harvesting is typically thought of as something to focus on near year-end, but financial advisers should work with their clients to harvest tax-losses throughout the year as appropriate.
For clients with taxable investments, tax-loss harvesting should be a tool advisers can use in managing portfolios during the year. Investments generally shouldn’t be sold just to realize a loss, but if some or all of an investment position merits a sale realizing the loss can be beneficial to a client.
Realized losses can be used to offset capital gains on other holdings in the portfolio, both realized capital gains from selling a holding and capital gains distributions from mutual funds. To the extent that losses exceed gains in a given year, the excess losses can be used to offset up to $3,000 of an investor’s ordinary income in that year. Excess losses above that amount can be carried forward to be used in subsequent years.
While realizing a tax loss should not be an objective in and of itself, if this can be done in the normal course of managing a portfolio, the tax savings may be beneficial to a client’s overall situation.
Part of the Rebalancing Process
As advisers work with clients to rebalance their portfolios, it's always a good idea to do this in the most tax-efficient way possible. If there are holdings that you would recommend selling as part of the process that have losses, this makes sense. Perhaps the client has a holding that you suggest selling a portion of as part of the rebalancing process.
If the holding was purchased in multiple lots and a portion of the shares currently show a loss, selling those shares as part of the portfolio rebalancing process makes a lot of sense. This type of situation illustrates the importance of using the specific cost method versus the average cost method of recording an investment’s cost basis when possible.
Matching Gains and Losses
In using tax-loss harvesting, it's important to be aware of the IRS ordering rules for matching long and short-term gains and losses.
Tax losses must first be matched against gains of the same type. Short-term losses against short-term gains, long-term losses against long-term gains. If losses of either type are greater than gains of the same type, the excess can be used to offset gains of the other type. For example, if the investor’s short-term losses are greater than their short-term gains for that year, any excess can be used to offset long-term capital gains if there are any.
When possible, it's usually a good idea to do what you can to minimize any short-term gains as they are taxed at ordinary income tax rates which are often higher than the preferential long-term capital gains rates.
Beware of the Wash-Sale Rule
Whether rebalancing or otherwise making adjustments in a portfolio, it's important to be cognizant of the wash-sale rule. This rule states that an investor cannot realize a loss on the sale of a security if they buy shares of the same or of a substantially identical security within a 61-day window that includes the 30 days prior and the 30 days after the sale that resulted in the loss.
Not trading in the exact same security is easy to understand. If you take a tax-loss on shares of IBM (IBM) - Get International Business Machines (IBM) Report it’s pretty straightforward that your client needs to not purchase additional shares during this 61-day period.
“Substantially similar” can be a bit tougher. For example, if your client sells shares of one S&P 500 mutual fund or ETF at a loss, if they buy another S&P 500 mutual fund or ETF from another fund company this would likely be considered a substantially identical security and the ability to deduct the loss for taxes would be disallowed.
However, if an S&P 500 fund was sold at a loss and the proceeds were used to purchase shares in a mutual fund that tracks the total U.S. stock market, this likely would not be considered a purchase of a substantially identical security since it likely tracks a different index and has a different investment objective.
The time restrictions for the wash-sale rules also extend to the client’s IRA account. They would also extend to a retirement account for the self-employed such as a SEP-IRA or solo 401(k). In other words you can’t sell a security for a loss and then purchase that security in the client’s IRA within the wash-sale period, doing so would disallow the use of the loss on the sale.
Adding Value as an Adviser
While most advisers likely agree that tax issues should be a secondary consideration when deciding whether to sell an investment, helping your clients make the most of any tax savings opportunities will be appreciated by them. As you manage their portfolio throughout the year, it makes sense to look for any tax-loss harvesting opportunities in the normal course of managing their investments.