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Last Minute Tax-Loss Harvesting Strategies

Tax-loss harvesting can be an investor’s ally after a year of volatility and portfolio losses. Here's how it works and how to use it.

Tax-loss harvesting can be an investor’s ally after a year of portfolio losses. So why don’t more investment professionals tout the tax and investment management practice?

It’s a fair question to ask.

Some trading professionals do break out the megaphone and extoll the potential benefits (and risks) of end-of-the-year tax-loss harvesting.

Exhibit A is Real Money contributor Jonathan Heller, who builds an annual tax-loss harvesting portfolio that points to the importance of good end-of-the-year investment tax management.

Heller’s 2021 Tax Loss Selling Recovery Portfolio was up about 50% through the first nine months of 2021, demonstrating the tax-advantaged possibilities of taking a tax harvesting stance.

That seems to be an opportunity worth pursuing. So, what should investors know about tax harvesting and, more importantly, how should they leverage the tax strategy to full advantage?

Let’s take a closer look.

Tax-Loss Harvesting Can Minimize Losses

In its basic form, tax-loss harvesting helps investors who’ve suffered portfolio losses during the calendar year minimize those losses, primarily through the U.S. tax code.

By harvesting portfolio investments to sell at a loss, an investor can leverage that loss to either reduce or stamp out any taxes owed on capital gains incurred during the same calendar year.

In short, any taxes owed on capital gains or regular tax income can be reduced through tax-loss harvesting, although there are asset limitations. By Internal Revenue Service statute, only taxable investment accounts are eligible for tax-loss harvesting. That means traditional retirement accounts like 401k plans or individual retirement accounts (IRA) aren’t eligible for tax-loss harvesting as they are not taxed for capital gains.

Stocks, bonds, mutual funds and exchange-traded funds, however, are eligible for tax-loss harvesting. For that matter, ordinary income can be impacted by harvesting, too. The tax-loss harvesting process allows an investment loss to offset taxes not just on capital gains realized in an investment portfolio, but as ordinary income on an investor’s tax return. Married couples filing jointly are limited to offsetting up to $3,000 annually in realized losses on their federal income tax returns.

I wish I knew then: Jeffrey Levine, chief planning officer at Buckingham Wealth Partners, on what he wishes he had known about tax losses and closing out a short position.

The Tax-Loss Harvesting Process

To understand tax-loss harvesting, one must understand the meaning of capital losses in investing.

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Capital loss represents any loss in an investor’s portfolio. Basically, capital loss happens at any point in time an investment asset falls in value. That loss, however, is not seen as a legitimate capital gains loss until the asset in question is sold at a price that’s lower than the investment's initial purchase price.

Let’s say an investor makes a $20,000 investment in ABC stock in January of 2021. By November, ABC stock had declined by 10% from the time the stock was purchased by the investor. That leaves $18,000 still invested in the stock, with a $2,000 loss. That $2.000 actually represents the investment’s “capital loss.”

Using tax-loss harvesting, the investor could sell the remaining $18,000 in ABC stock, thus locking in the $2,000 capital loss. Under tax-law harvesting rules, the $2,000 in ABC stock losses could result in the realized loss being used to offset either any capital gains or taxes earned as ordinary income, and potentially reduce that investor’s overall tax burden.

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Depending on that investor’s tax bracket, tax-loss harvesting may represent a significant tax break for the 2021 tax year. In general, the higher the investor’s tax bracket, the more that investor sees taxes reduced through harvesting.

Red Flags With Tax-Loss Harvesting

Not every portfolio investment loss leads to an ideal tax-loss harvesting opportunity.

For example, the IRS may reject a so-called “wash sale” where an investor deducts a capital loss on an investment asset against any capital gain garnered by the same security that’s purchased 30 days before or after a tax-loss harvesting transaction is completed.

Additionally, the service fees that come part and parcel with the tax preparation side of tax harvesting can add up, especially if the taxpayer is engaging in numerous tax-loss harvesting market transactions. That could cut into any capital gains or ordinary income tax savings earned via tax-loss harvesting.

Investors also need to be efficient record keepers when engaging in tax-loss harvesting.

For instance, the IRS may want to review each transaction made in the harvesting process and ensure they were each made with the proper cost basis (i.e., the various prices paid or sold for during the tax-harvesting process.) If those records aren’t accurate, that could lead to tax return problems and higher taxes paid, depending on any IRS review of the harvesting process.

Good Way to Offset Tax Penalties From by High Capital Gains

By and large, any investor looking to leverage tax-loss harvesting should consult with a trusted tax professional or financial adviser to ensure any tax-harvesting advantages are worth the effort.

That said, if you have substantial realized capital gains in 2021, but still have some investment losses, tax-loss harvesting can be a good way to offset tax penalties imposed by high capital gains.

That will keep more of your own money in your pocket – and less in the pocket of Uncle Sam.