LEVATUS Q & A | The Market Is Not Going Up! What Can I Do? | Tax Loss Harvesting
With early year realized capital gains in the books, what do you do now in the wake of the subsequent market downturn?
Photo by Sies Kranen
The 2022 market swoon was born out of the massive post pandemic market rally of 2021, a rally that began to turn just as we rounded the corner to the new year. For those who trimmed positions in early 2022, in anticipation of rockier roads ahead, capital gains were likely realized. While this created a more conservative positioning going into what has proven to be a tough year for markets, it also created a tax liability.
With early year capital gains on the books, what do you do now in the wake of the subsequent market downturn? Next in our series, The Market Is Not Going Up! What Can I Do?, we highlight the power of Tax Loss Harvesting.
What is Tax Loss Harvesting?
As highlighted in the Wall Street Journal, tax-loss harvesting is a strategy to lower current federal taxes by deliberately selling positions that are at a capital loss to offset taxes owed on capital gains. The investment can be any tradable security - stocks, bonds, shares in an ETF or even cryptocurrencies. It is important to note that tax-loss harvesting is only relevant for taxable investment accounts, as retirement accounts are sheltered from capital gains taxes.
The bottom line: you are only taxed on net capital gains, so any realized losses will lower your tax bill.
Why is now a good time to implement this strategy?
At LEVATUS we believe an active strategy around tax loss harvesting is best implemented throughout the year. With that said, the most common time for many is year-end, when annual income taxes are looming. December 31 is the deadline to take the capital losses that will be used to offset capital gains for that year.
The rationale behind tax-loss harvesting is that deferring current tax payments allows investors to use the savings to fuel portfolio growth in the present. By reviewing your total estimated tax liability so far in 2022 now, you have sufficient time to assess any losses you may have as a potential way to offset that tax liability.
The bottom line: You have until December 31 to sell securities to offset gains for this year. Generally speaking, though, it is best to think about tax loss offsets throughout the calendar year.
Can you show me an example of how Tax Loss Harvesting works?
Let’s imagine you buy Stock A with a cost basis of $150,000 in a taxable account.
You now sell Stock A for $170,000 and realize a capital gain of $20,000
You have another Stock B with a cost basis of $130,000
You can sell Stock B at $107,000 and “harvest” the price difference of $23,000 as a capital loss
In the example above, the investor can use their capital loss of $23,000 dollar for dollar to offset their entire capital gain of $20,000 this year—and the remaining capital-loss balance of $3,000 can be carried over to offset future capital gains until it is used up.
The bottom line: In this example you will have saved the taxes due on the $20,000 gain by creating the offset.
Are there any restrictions on Tax Loss harvesting?
Losses of one type must be used first to offset gains of the same type. Short-term capital losses must be used first to offset short-term capital gains; long-term capital losses must be used first to offset long-term capital gains. Fortunately, if losses in one category exceed gains in the same category, then the remaining losses can be applied to gains in the other category. This is certainly an area a tax professional should weigh in on.
The Wash-Sale Rule - Most investors who use tax-loss harvesting to lower their taxes want to maintain their level of exposure to the sector in which they took capital losses. Although reinvesting after realizing capital losses is allowed, investors must be careful not to violate the wash-sale rule—or the IRS will disallow the offset of capital gains. To prevent investors from gaming the system to get a tax break, the tax code prohibits investors from deducting capital losses on what the IRS calls "wash sales.” This means that investors must refrain from purchasing an identical or “substantially identical” security—or even an option to buy such securities—for 30 days before and 30 days after the capital loss is realized.
There is some flexibility to use capital losses to offset income, but that is limited. There is an annual limit of $3,000 and special forms must be submitted by your accountant to claim this.
The bottom line: As with so many tax related strategies, some of the rules around tax loss harvesting can be tricky. It is important to understand restrictions and consult your accountant with any questions.
Is Tax Loss harvesting a Silver Lining in the storm?
Tax loss harvesting is an important tool. While it requires a little extra work and some expertise to implement effectively, tax loss harvesting can create an effective offset to current year taxable gains, thereby easing the current year tax liability.
First and foremost, you want to make sure any plan around Tax Loss Harvesting fits with your bigger picture portfolio strategy. This is a critical point that many miss. When there is an alignment between tax efficiency and long-term strategy, tax loss harvesting can be a beautiful thing indeed.
The information provided is for informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
Views and opinions are subject to change at any time based on market and other conditions. Any projections, market outlooks, or estimates in this presentation are forward looking statements and are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Levatus LLC is a registered investment advisor. Levatus provides investment advisory and related services for clients nationally. Levatus will maintain all applicable registration and licenses.
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ABOUT THE AUTHOR
Liz Darling is a Senior Client Advisor and founding member of LEVATUS Wealth Services. Her professional background includes institutional real estate investment management, wealth planning and hospitality management. Coming from an institutional background, Liz’s favorite part of her day is interacting with her clients on the little things that she can do to make their lives and their financial situation simpler and clearer. Liz taps into her years of experience to write on topic such as, the role of real estate in generational wealth building, the power of straightforward strategy and planning, and how best to address the many ways wealth can impact children.
August 2024 started with a swift drawdown in markets. As with many such corrections, a major contributor was leverage.