Maximizing Returns Through Tax Loss Harvesting
As an investor, you’re always looking for ways to maximize your returns and minimize your tax liability. One strategy that can help you achieve both of these goals is tax loss harvesting.
Tax loss harvesting is the process of selling investments that have decreased in value to offset capital gains and reduce your tax bill. By strategically selling these investments, you can minimize your tax liability and potentially increase your overall returns.
In this article, we’ll explore the basics of tax loss harvesting, including what it is, how it works, and how you can implement it in your investment strategy.
What is Tax Loss Harvesting?
Tax loss harvesting is a tax strategy that involves selling investments that have decreased in value to offset capital gains and reduce your tax liability. This strategy is typically used by investors who have realized capital gains from selling investments at a profit.
For example, let’s say you have a stock that you purchased for $10,000 and it has increased in value to $15,000. If you sell this stock, you will have a capital gain of $5,000, which will be subject to capital gains tax. However, if you also have another stock that has decreased in value by $5,000, you can sell it to offset the capital gain from the first stock. This will result in a net capital gain of $0, meaning you won’t owe any capital gains tax on the sale.
How Does Tax Loss Harvesting Work?
Tax loss harvesting works by taking advantage of the tax code’s treatment of capital gains and losses. When you sell an investment at a profit, you realize a capital gain, which is subject to capital gains tax. However, when you sell an investment at a loss, you realize a capital loss, which can be used to offset capital gains and reduce your tax liability.
There are a few key things to keep in mind when implementing a tax loss harvesting strategy:
You can only use capital losses to offset capital gains. You cannot use capital losses to offset other types of income, such as wages or interest.
If you have more capital losses than capital gains, you can use up to $3,000 of the excess losses to offset other types of income. Any remaining losses can be carried forward to future tax years.
If you have both short-term and long-term capital gains, you must first offset short-term gains with short-term losses and long-term gains with long-term losses. If you have both short-term and long-term losses, you can use them to offset either type of gain.
Implementing Tax Loss Harvesting in Your Investment Strategy
Now that you understand the basics of tax loss harvesting, let’s explore how you can implement it in your investment strategy.
Keep Track of Your Capital Gains and Losses
The first step in implementing a tax loss harvesting strategy is to keep track of your capital gains and losses. This will help you identify opportunities to offset gains with losses and minimize your tax liability.
You can keep track of your capital gains and losses by reviewing your investment statements or using a tax software program. It’s important to review this information regularly, as it can change throughout the year as you buy and sell investments.
Be Mindful of Wash Sale Rules
One important consideration when implementing a tax loss harvesting strategy is the wash sale rule. This rule states that if you sell an investment at a loss and then purchase a substantially identical investment within 30 days before or after the sale, you cannot claim the loss for tax purposes.
For example, let’s say you sell a stock at a loss and then purchase the same stock or a similar stock within 30 days. In this case, the loss from the sale would be disallowed, and you would not be able to use it to offset capital gains.
To avoid violating the wash sale rule, you can either wait at least 30 days before repurchasing the investment or purchase a different investment that is not substantially identical.
Real-World Examples of Tax Loss Harvesting
Let’s take a look at a few real-world examples of tax loss harvesting to see how it can be used to minimize tax liability and potentially increase returns.
Value Of Reviewing Prior Year Tax Returns
Since net capital losses can be carried forward to future years, it pays to review prior year tax returns to see if any carryforward capital losses exist. To do this, find Schedule D (is applicable). Here is a snapshot of what you are looking for.
Look to see if there is a balance on line 16. If there is, subtract $3K from this amount (because this is what you were able to use against other forms of income last year). This number represents your net carryforward losses. Knowing that you have carryforward losses available could very well influence what positions you may sell in the event you need cash for some reason.
Real Estate And Capital Losses
Real estate is a capital asset and profits/losses are considered a capital gain/loss. This is important to remember because nonretirement investment accounts also fall within the same tax category. This means that selling real estate as well as positions within your nonretirement account will both be reported on Schedule D and this might present an opportunity. Let's look at an example.
Jon and Sally bought a vacation property five years ago for $500K. They recently decided to sell the property and after realtor commissions walked away with $600K. Since real estate is a capital asset, they need to report this sale on Schedule and will need to report a profit of $100K. Fortunately Jon and Sally use the amazingly talented financial advisory firm Stonehearth Capital Management located in Danvers MA and their financial advisor identified that one of Jon's stocks that he inherited from his father has lost $120K since his father's passing. They agreed to sell this position to lock in the $120K loss. This loss is able to fully offset the $100K profit they realized when they sold their vacation home.
Losses are never fun, but it helped save Jon and Sally about $15K in taxes that they otherwise would have owed on the sale of their vacation home, turning a loss into a win.
Conclusion
Tax loss harvesting is a powerful tax strategy that can help you minimize your tax liability and potentially increase your returns. By keeping track of your capital gains and losses and being mindful of wash sale rules, you can implement a tax loss harvesting strategy that is tailored to your specific financial situation. And, as always, it’s important to consult with a financial advisor (like us) before making any investment decisions.