Updated October 7, 2021
Writing off losses and business expenses in order to lower taxable income is standard practice among entrepreneurs and business owners. For individuals who have been classified by the IRS as day traders, there are certain mechanisms of tax loss harvesting that are not available to the general public, though regular taxpayers can also leverage tax loss harvesting from investment income to lower their ordinary taxable income.
Tax Loss Harvesting Rules
- Wash-Sale Rule
- Cost Basis Analysis
Stocks, bonds, and ETFs are just a few examples of securities that can be sold at a loss to lower your taxable burden. Taxpayers who don’t plan on repurchasing the securities or similar securities within a 30-day period can use this strategy to report a loss and reduce their tax burden, if their income is sufficiently sizable enough to bump them into an undesirable tax bracket.
However, casual retail investors who do repurchase the security (or arguably similar securities) within a 30-day period are violating the IRS’s wash sale rule. Though making this type of wash sale (that is, selling a security at a loss and then repurchasing it within 30 days) is not outright illegal, leveraging the loss as a tax benefit is unless you are a day trader.
In looking at tax loss harvesting, it’s also important to understand the difference between short-term and long-term gains and losses when it comes to paying taxes. Short-term capital gains and capital losses relate to assets that have been held for less than one year, while long-term capital gains and capital losses are realized on assets that have been sold after owning them for a year or more. This could be decades in the case of some assets.
Short-term capital gains are taxed as ordinary income under a marginal tax rate, the highest of which is 37 percent. State and local taxes can add to this amount, of course.
Long-term capital gains have a more favorable rate. Single tax filers making $40,000 or less and married couples filing jointly making $80,000 or less will not have to pay anything on long term capital gains. Anything more than that but less than $441,450 for a single filer and $496,600 for a couple will result in a 15 percent tax rate. It is a 20 percent tax rate for individuals making more $441,450 and couples making more than $496,601 on the sale of an asset.
The upshot of this is that short-term capital gains can carry a punitive tax rate that eats away at hard-earned profits Because the rate is based on the amount of gain, it is recommended that a taxpayer lower that amount by any means necessary, even at a technical loss (if it is strategic). This is where tax loss harvesting comes in.
What is Tax Loss Harvesting?
Individuals who do not qualify as day traders according to the IRS can sell their securities, but they cannot repurchase identical securities or similar securities within a 30-day time period. Keep in mind that this does not just relate to identical stocks.
For example, a taxpayer who owns shares in a mutual fund dedicated to a certain index of tech stocks cannot cash out on that fund for a loss to report on their tax return and then reinvest that cash in a different mutual fund that also specializes in the exact same index of tech stocks. In order to make sure you are not running afoul of tax law, speak to the advisor in charge of your tax planning.
However, individuals who engage in buying and selling stocks full time with the intent to make a profit while leveraging professional resources in the pursuit of said profit) can fill out certain paperwork with the IRS and obtain the right to elect mark to market accounting. This process awards the tax payer day trader status and allows them to legally do a wash sale and record it as a loss for tax purposes.
Tax Loss Harvesting Rules
As mentioned earlier, a wash sale involves selling a security (like stocks, bonds, or shares in a mutual fund) for a loss, and repurchasing it 30 days later. This is not a legal financial strategy for the average taxpayer, but it is available to those involved in day trading.
Day trading individuals will need to pay day trading taxes, and their day-to-day trading activity must be acknowledged by the IRS through the requisite paperwork.
A married-filing-jointly taxpayer who has not received day trader status from the IRS cannot claim more than $3,000 in losses against their taxable income in terms of buying and/or selling securities. That amount drops to no more than $1,500 if the taxpayer is a single filer. This is actually a fairly low amount, and there are many other types of tax breaks available to Americans, some of which can add up to an amount greater than $3,000.
This threshold makes tax loss harvesting a fairly useless tax break mechanism for the average taxpayer since in most cases $3,000 will not be the amount that makes or breaks their arrival into a more desirable tax bracket.
It’s also important to note that this $3,000 benchmark is for capital gains or losses on investments. If you’re self-employed or run a business, you are certainly allowed to deduct more than $3,000 of business expenses from your gross annual income, but as it relates to tax harvesting, there is a threshold for the average taxpayer, and this threshold (for most individuals) means that tax loss harvesting is not a helpful strategy.
Cost Basis Analysis
Determining the capital gain or capital loss of a security is not as simple as taking its price at purchase and subtracting from that number its price at sale. Rather, the taxpayer must perform a cost basis analysis. This accounting practice adjusts the original value for dividends and stock splits, where applicable.
What Are the Risks of Tax Loss Harvesting?
Remember, according to the wash sale rule, you cannot sell a security and then repurchase an identical or similar security. This can sometimes force investors to purchase a security that underperforms its replacement in order to avoid violating the wash sale rule.
For example, if a retail investor owns shares of Coke, and then sells those shares at a loss to lower their tax burden, they could then purchase shares of Pepsi to avoid violating the Wash Sale Rule. While it would certainly be disappointing if Pepsi underperformed Cok, the two beverage companies would not be considered a substantially identical security.
There is also the risk, on the flip side, that the replacement security could outperform its predecessor, triggering a potential short-term capital gains tax on the profit.
All that said, tax loss harvesting is not really a safe and viable strategy for the average casual investor looking to pay less taxes. It’s a strategy best leveraged by financially savvy individuals who are familiar with the idea of balancing and rebalancing an investment portfolio by shifting assets around in order to maximize profits and minimize benefits. Such individuals who understand asset allocation and the balance between return and risk are best suited for using a tax loss harvesting strategy to reduce their taxable burden.
An great example of someone who would benefit from tax loss harvesting is an investor that can turn the unrealized loss of a security by selling it at a loss and using it to offset the short-term capital gain of a different investment.
Tax Harvesting Accounting Example
Let’s say it is time for an investor to pay their income tax. This investor has four different portfolios.
- Portfolio A has yielded $150k of unrealized loss and has been held for three years.
- Portfolio B has yielded $100k of unrealized loss and has been held for just 50 days.
- Portfolio C sold for realized gains of $250k after four years of holding.
- Portfolio D sold for realized gains of $180k after six months of holding.
If this investor did not employ a tax loss harvesting strategy, they would be looking at the following taxation on their capital gains:
Portfolio C is a long-term asset, so its sale will be subject to a 20% tax rate.
Portfolio D is a short-term asset, so its sale will be subject to a 15% tax rate.
So, $250,000 x 20 percent (long-term capital gains tax rate) = $40,000, while $180,000 x 15 percent (short-term capital gains tax rate) = $27,000. This results in a total tax burden of $67,000.
If harvesting losses becomes part of the plan, however, that number would be lower. In this case, let’s say the investor decides to liquidate portfolios A and B. Keep in mind that short-term capital gains and long-term capital gains need to be calculated together. Now our tax burden is:
- ($250k – $150k) x 20 percent = $20k (a number much less than the original $40k calculation)
- ($180k – $100k) x 15 percent = $15k (less than the $27k from the original calculation)
In this case, tax loss harvesting means the investor only has to pay $35k in taxes instead of the original $67k.
Of course, an investor will need to figure out if tax loss harvesting offsets the losses from their portfolio, and if the cash accrued from the sale of their investments can be leveraged into more attractive investments.
Tax Loss Harvesting is Beneficial for Taxpayers Who Frequently Buy and Sell Investments
If you’re not a professional investor, you might not meet the requirements for tax loss harvesting to be advantageous. Generally, you have to be buying and selling investments on a frequent basis. Otherwise, you won’t have enough capital gains income for it to even be a factor.
However, tax loss harvesting can be a great strategy for individuals who know how to use it to their advantage. It’s a great strategy to offset capital gains tax obligations while minimizing losses.
Your best bet when it comes to paying less taxes is to consult with a tax professional who can review your income and financial goals while guiding you towards the most applicable and beneficial tax strategy.
If you’re looking for more great tax tips to save money, join Toby Mathis for his weekly Tax Tuesday webinar.
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