Tax-loss harvesting – purposefully selling certain investments at a loss to offset realized gains on other investments – is a strategy for counteracting high gains taxes. While most investors are aware of tax-loss harvesting, many view it as a task performed at the end of the year.
But, given the current dip in the market, staying vigilant for opportunities year-round and understanding tax rules that influence tax-loss harvesting can help investors fully realize their earning potential.
Here are a few things to keep in mind.
Short-term vs. Long-term
Investors can use short-term and long-term losses on specific investments to counteract gains on other investments, but it is vital to understand what balances what.
Short-term losses counter all short-term gains before they begin to counter long-term gains. Long-term tax harvesting works similarly; long-term losses counter all long-term gains before countering short-term gains.
So, should investors focus on counteracting short-term or long-term gains? While every tax situation is unique, using short-term losses to counter short-term gains can create more tax harvesting opportunities due to differing federal tax rates. Long-term gains face a 20% maximum federal tax rate; short-term gains face a 37% maximum rate. These differing rates mean short-term gains – and their higher tax rates – typically create more tax-saving opportunities.
The Wash-Sale Rule
Investors should also consider the time between purchasing and selling investments when harvesting tax losses.
The Wash-Sale Rule – created and enforced by the IRS – prohibits investors from taking tax deductions on investments sold in “wash sales.” Wash sales occur when investors sell/trade investments at a loss, then repurchase those same investments (or “substantially identical” investments) within 30 days before or after the sale.
Investors can still quickly repurchase recently-sold assets, but these actions will be ineligible for tax-loss harvesting.
Limitation and Location
Investor location also plays a significant role in the benefits of tax-loss harvesting. Typically, harvestable tax losses are limitless. But, investors can only mitigate $3,000 worth of capital gains through tax-loss harvesting per year on ordinary income. This cap doesn’t mean that more than $3,000 worth of harvesting in a given year is useless – any losses past that initial $3,000 will carry over to the next year and so on.
Certain states do not follow this rule, however. Harvesting more than $3,000 in losses per year in these states will not see that overflow carry over into subsequent years, making extensive tax-loss harvesting pointless. Investors should check their state tax rules for clarification.
Tax-loss harvesting is a valuable tool for investors, but it can be misused. Breaking tax rules or being uninformed on specific rules can lower potential returns from tax-loss harvesting or undo its benefits altogether.
It’s up to investors to use tax-loss harvesting correctly and other financial tools and strategies to fully maximize their tax-saving potential.
Contact your financial advisor to create a tax loss strategy or reach out to the tax accountants at Borland Benefield for more information.