Tax Loss Harvesting – Is it Legal?

Yes, it’s legal. Tax-loss harvesting is a strategy to reduce the taxes an investor pays on capital gains.  There are some rules to be aware of, but overall, it works.

Capital gains are the profit from selling an asset for more than it cost. Those assets include stocks, bonds, and precious metals. For long term capital gains to apply the asset must be held for at least one year.

A short-term capital gain is when an asset owned for less than a year. Short term capital gains are taxed as income. You pay the same rate you’d pay your ordinary income taxes. The tax brackets on long term capital gains are more advantageous for the investor.

Both can be used to offset an investor’s tax liability. One for long term capital gains, the other for personal income taxes.

How Tax Loss Harvesting Works

Tax harvesting is also called tax-loss selling. That’s because investors sell at a loss to offset gains on a purchased asset.  With tax-loss harvesting, an underperforming investment is sold. A similar investment is bought that balances the portfolio to the anticipated risk and return ratio.

Tax-loss harvesting is typically implemented at the end of the calendar year when the tally is clear. But the sale and replacement of underperforming investments can be made at any time. The ultimate goal is to rebalance your portfolio and get a tax benefit for doing it.

There are 3 basic steps to get the benefit:

  • Sell an asset that’s losing money or underperforming.
  • Reinvest the money in another asset to diversify and rebalance your portfolio.
  • Apply the loss:
    • to reduce the amount of tax on capital gains.
    • to reduce your personal taxable income
    • to offset taxable personal income in future years.

Here’s an example:

  1. You have investments in hotels and hospitality industries.
  2. You own stock in social media and tech networks like Cisco.
  3. The coronavirus hits.
  4. Your investments in hotels and hospitality tank. You sell them at a loss.
  5. You reinvest the money in a company that manufactures masks.

You’ve rebalanced your portfolio and compiled with the IRS Wash Rule. The Wash Rule keeps investors from taking advantage of the system.

Wash Rule: Investors can’t dump a stock that tumbles, then buy it back on a rebound within a 30 day period. If you sell at a loss and buy the same or “substantially identical” asset within 30 days, you don’t get the tax break.

We used covid-19 as an external event that had sweeping impacts across the market. It’s clear in this example that the investor won’t be buying hotel/hospitality stocks anytime soon.

But in a different scenario, a hospitality group’s restaurant has a food poisoning outbreak. You dump the stock and invest in a “substantially similar” restaurant group. You make the buy within a week of the original sale.

No tax write-off for you.

Wash Rule Workarounds

There are always ways to manage your portfolio and reduce tax liability.  The larger the value of your investments, the more beneficial tax-loss harvesting can be.

Example 1: Your investment in Facebook takes a tumble and you sell it for a loss. As stocks are inclined to do, it starts to rebound. If you want to buy it back, you have to wait 30 days. If it’s a recent investment, you can’t even sell it for 30 days if you want to realize the loss. Then it’s another 31 days before you could repurchase it.

Example 2: Your investment in a mutual fund underperforms. You sell the asset and want to realize the loss. You can replace it with another mutual fund as long as it tracks a different index. (Similar but not “substantially identical.)

FYI – you can’t skirt the Wash Rule by buying the old asset back with another account, like an IRA.

Not Just For The Wealthy

wealthy women

The general impression is capital gains are only for the wealthy. Maybe so, but tax-loss harvesting is not. You can apply a loss to your personal taxable income, no matter how much you’re worth.

Let’s say you bought $12,000 of stock a few years ago. The stock is under-performing, sale value of $8,000.  You take the of loss of $4000.  You use the $8,000 to buy a different stock to round out the portfolio.

You can take some percentage of the $4000 off your personal income taxes.  Multiply the 4K by your tax bracket and that’s how much you can deduct.  If you’re in a 30% bracket, the formula is [ 4000 x .30]to deduct $1200 on your personal income taxes.

If you put the deduction in a high-yield savings account, it’s a low-risk step to financial independence. If you prefer, put it back in the market. Either way, you’re making money on the money you have.

More Losses than Gains

Here’s the other side of the coin – what if the losses are more than the gain? Tax harvesting is a solution. You can offset up to $3000 of on your income taxes. If you’re married and filing separately, split the deduction between you.

If you have significant losses, much more than a $3000 tax break, there’s more good news. The leftover loss amount can be carried over until it’s depleted. So you can use it to offset income in future tax years.

Summing Up

Tax harvesting works best if you offset your losses from capital gains of the same type. You want to put up long-term gains against long-term losses to get the maximum benefit. If you need to include losses from short-term capital gains, tax liability may apply to your personal income.

All investors can use investment losses to lower their tax liability. But long-term capital gains tax rates make tax harvesting losses more valuable for high-income investors.

Capital Gains Tax Rates

Long term capital gains receive a more favorable tax adjustment. They are not taxed as income, which for wealthy investors is a significant saving. The difference between capital gains and capital losses is called “net capital gain.”

There are only 3 brackets for taxing net capital gains. The rates are progressive, similar to income taxes. As per the IRS, the 2021 tax rates for capital gains are as follows.

Here’s how those same rates would compare if capital gains were taxed as income.

2021 tax brackets

Keep in mind that income taxes are also progressive. There are 7 brackets. Taxes are accrued at the rate of each bracket. Only a portion of your income is taxed at the highest rate. Even so, capital gains tax rates are extremely favorable when compared to income taxes.

(Both these tables use IRS projections for 2021. But always consult your CPA or attorney for personal tax liability issues.)

Be aware that not all capital gains are treated equally. The first 28% of capital gains on art, coins, and antiques are taxed as personal income. If you make $90,000 by selling historical memorabilia – $25,200 of it hits your personal income tax bracket. The remaining $64,800 is taxed as a capital gain.

When you sell your home, you may qualify for zero tax on the capital gains from the sale. A principled residence means you’ve lived in the home for at least 2 of the last 5 years. There are a few other conditions but up to $500,000 for a married couple (half that for single owner) are tax exempt

If you invest in a designated Opportunity fund, capital gains are not taxed. A qualified opportunity fund (QOF)invests money in a property within an Opportunity Zone. The IRS has an FAQ on the funds here.

Net Investment Income Tax (NIIT)

The Affordable Care Act created a 3.8% “net investment income tax,” to fund Medicare expansion. The provision targeted higher earners and set an income threshold to trigger payment.

The net investment income tax only applies to investment income. Your net investment income includes:

  • Capital gains (short- and long-term)
  • Dividends
  • Rental and royalty income
  • Passive income from investments you don’t actively participate in
  • Business income from trading financial instruments or commodities
  • Taxable portion of nonqualified annuity payments

NIIT does not include wages or salary, Social Security, unemployment benefits, veteran benefits, pensions, or life insurance. It doesn’t include the gain on the sale of a primary residence that has no tax liability.

The NIIT income threshold amounts are:

  • Single or head of household: $200,000, or
  • Qualifying widow(er) with a child: $250,000
  • Married filing jointly: $250,000,
  • Married filing separately: $125,000

(The IRS uses your adjusted gross income – AGI to determine your NII.)

Here’s how a payment works. The tax applies to your NII or whatever amount of it goes over the threshold, whichever is less.

A married couple has a net investment income of $320,000. They are $70,000 above the threshold. They pay the 3.8% tax on the $70k, not the $320,000.  You pay $2600 in tax.

About Mutual Funds

You can treat some dividends from funds as capital gains. If you plan to harvest a loss, confirm the dividend is considered qualified by the IRS. Any dividend on mutual fund shares held less than 61 days is a nonqualified dividend. The 61-day timeline is determined by how long you’ve owned the shares before you try to sell them.

The 6 Month Rule

If you sell shares of a mutual fund you’ve had for less than 6 months, claiming the loss may include some restrictions. If the shares provided tax-exempt interest, it gets paid back from the loss claim.

Most mutual funds (but not all) that pay monthly dividends are likely to be subject to the 6-month rule. Check the prospectus. If it reads “dividends are declared monthly,” the rule applies.

Charitable Gifts

Tax harvesting is designed to reduce tax liability on long term capital gains. If you’ve held shares in a mutual fund for over a year, you can avoid tax by donating shares to charity. This can help offset your total capital gains rate and reduce your net investment income. The IRS has a publication explaining charitable donations.

If you donate $15,000 in mutual fund shares but only paid $10,000 for them, you reduce capital gains by $5,000. This benefits the charity but also your tax liability on that $5k is zero.

Don’t donate shares that are underperforming directly to a charity. Sell them to claim the loss to lower your taxable income. Then if you want to help out a non-profit, donate the proceeds of the sale,

The Bottom Line

Tax-loss harvesting is a valuable tool for reducing taxes and managing your portfolio. Offsetting capital gains by taking the right losses will help rebalance your position. Rebalancing helps realign your asset allocation for a balance of return and risk.

Even in the worst bear market, the strategy will help relieve the stress of tax liability. It can’t fix the market, but it can get your portfolio in a stable position.

Rebalancing is key to keeping your portfolio diversified. Every investor has a vision of risk and reward. That’s the guide to follow when choosing what to keep and to sell. Tax management is important, but not the only variable for investors.

Harvesting losses regularly can save you money over the long run, effectively boosting your after-tax return. For some investors, it’s a proactive tool to manage their portfolio. Tax-loss harvesting is strategic and should align with your overall investment goals.

The primary consideration for any tax-loss harvesting decision is the status of your gains and losses. It’s always a good idea to consult your CPA or tax attorney to confirm information you’ve been told or read online. Get the expertise to help you stay on track with your investment strategy. Tax-loss harvesting is just one piece of the puzzle in portfolio management.

 

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