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Tax Loss Harvesting

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Tax Loss HarvestingHas the stock market decimated your portfolio too? Yeah, us too. Fortunately, there’s something called tax loss harvesting and it can help anyone get a little edge on the recovery. The idea behind tax loss harvesting is that you sell a particular holding, take the capital loss, and then immediately invest it in something similar but not the same as the original holding. By doing this, you “harvest” some of your losses to offset gains or ordinary income, and by investing in a similar but not a “substantially identical security,” you also benefit from the recovery. The key in this strategy is that you invest the tax savings, from the loss, back with the original sum.

Some words of advice on tax loss harvesting:

  • The reason why you can’t by something “substantially identical” has to do with the wash sale rule. If you want to deduct the loss, you have to follow wash sale rules.
  • Don’t do this in a retirement account. There is no capital gains or losses tax in retirement accounts. 401(k)’s and IRAs appreciate without taxes and taxes are only assessed at distribution time (with the exception of Roth IRAs, which are never taxed).
  • Substantially identical is a gray area because the IRS hasn’t clearly defined it but make sure it passes the sniff test. One interesting thing of note is this explanation on IRS Publication 564: “Substantially identical. In determining whether the shares are substantially identical, you must consider all the facts and circumstances. Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund.” The key word there is ordinarily. Just pass the sniff test, I’m sure your nose works well. :)
  • If your capital losses exceed your gains, you can deduct $3,000 of capital losses against your ordinary income. If your losses exceed that, you can carry those losses forward each year without limit.
  • You don’t have to wait until the end of the year to do this, in fact it’s probably better to give yourself the flexibility of doing this earlier in the year because of wash sale rules.

Why Tax Loss Harvesting Works

Let’s consider the scenario where a fund has dropped 10%, the investor opts to harvest losses and immediately invests in a fund that closely mimics the original fund. Both the original fund and the new fund appreciate by 11.1%. The investor invested $10,000 and is in the 25% tax bracket. Who wins?

Does not tax loss harvest: This scenario is simple, the investor has effectively had no change because the original fund has return to its original value. He sells and has no capital gains or losses.
Does tax loss harvest: The fund fell in value from $10,000 to $9,000 and the investor does some tax loss harvesting to extract the $1,000 in loss. The $1,000, come tax time, will yield him $250 in tax savings. He reinvests the $9,250 into a similar but not “substantially similar” fund and it appreciates by 11.1% to $10,276.75. When he sells, he pays taxes on $1026.75 of capital gains – or $256.69. Subtract that from his $10,276.75 and he’s left with $10,020.06, which is $20.06 ahead of what he had if he hadn’t harvested losses.

Tax Loss Harvesting with Placeholders

Let’s say that you really like a particular mutual fund, your brokerage doesn’t offer anything similar, and you aren’t about to open up another account at another brokerage just to do this tax loss harvest. A potential option is to use exchange traded funds (ETFs) as a placeholder for the wash rule period. Sell your loss, buy into an ETF, wait 31 days, then sell the ETF and get back into your fund. By selecting a similar ETF, you can catch any rises in the industry without sitting on the sidelines.

Please consult with an accountant to clarify your particular situation before doing anything I’ve talked about here.

(Photo: tonivc)

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5 Responses to “Tax Loss Harvesting”

  1. Cameron says:

    Can you do this with an individual stock? And if Yes what would constitude similar in this case do you thing? The sector the stock is in?

  2. jim says:

    Yes you could and the wash rule would only apply to the company. If you sold shares of Bank of America (BAC) you couldn’t buy shares within 30 days, but you could buy shares of Wells Fargo (WFC). The difficulty with individual stocks is that it’s difficult to find something that other option you can put the money in for 30-31 days. With mutual funds, you can swap one fund for another fund more easily.

  3. Miss M says:

    It looks like this only works for no load mutual funds or maybe if you use Zecco, in the scenario you show the difference is only $20. Commissions or trade costs would quickly eat through that.

  4. jim says:

    That was just the example, you can have fees and such, they are just deducted as they normally are.

  5. Rich says:

    Looks to me like the annual (usually in December) mutual fund capital gains distribution could be regarded as a purchase and result in a wash sale if it occurs within 30 days of a mutual fund sale made with the goal of tax loss harvesting. For example I have shares of an index mutual fund in both IRA and non-IRA accounts. If I sell my non-IRA account shares and retain those in the IRA (since there is no tax consequence of selling them at a loss), the capital gains distribution to the IRA account could result in the purchase of new shares that would be considered a wash sale.


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