Tax Loss Harvesting - Making the Best Out of a Bad Situation

Highlights:

• Every investor will incur losses now and then.
• Tax loss harvesting is a strategy for maximizing the tax benefits associated with capital losses.
• Capital losses must be recognized before December 31^st in order to lower this year’s tax bill.

 Things turn out the best for those who make the best out of the way things turn out.

            Art Linkletter.

Even the best investors can make poor investments.  In 1993, Warren Buffett purchased Dexter Shoe Co. for $433 million.  Rather than paying with cash, Warren decided to use Berkshire Hathaway treasury stock to fund the purchase.  As it turned out, Dexter Shoe became worthless, while Berkshire stock soared.

In his 2007 letter to Berkshire Hathaway shareholders, Mr. Buffett didn’t pull any punches when acknowledging his mistake:

“I made one particularly egregious error, acquiring Dexter Shoe for $434 million in 1993.  Dexter's value promptly went to zero.  The story gets worse: I used stock for the purchase, giving the sellers 25,203 shares of Berkshire that at year end 2016 were worth more than $6 billion. …  As a financial disaster, this one deserves a spot in the Guinness Book of World Records,” he wrote.

As we’ve discussed previously, rules-based, tactical asset allocation strategies that have been thoroughly backtested can help you avoid making investments you will later regret.  However, as discussed here, even sound investment strategies will hold positions that lose value from time to time.

While no one likes to see red numbers on their account statements, “tax loss harvesting” can help you turn those lemons into lemonade.  The term tax loss harvesting refers to selling a security at a loss and reinvesting the sale proceeds in a similar, but not “substantially identical”, investment. 

Capital loss harvesting is advantageous because realized capital losses can be subtracted from capital gains, allowing you to lower your current tax bill, and leaving you with more money to invest.  Furthermore, harvested capital losses can also be used to offset up to $3,000 of ordinary income.

Capital losses on securities held in tax-free accounts such as IRAs and profit-sharing plans, are not deductible.  In addition, the so-called “wash-sale rule” precludes a capital loss deduction if the same or a “substantially identical” security is repurchased in 30 days. 

The wash sale rule introduces the risk that positions you sold at a loss could recover lost ground during the 30-day waiting period.  This risk can be minimized, and in some cases largely eliminated, if the proceeds from the sale are reinvested in another security that is closely correlated, but not “substantially identical” to the one that is being sold.

It’s important to note that the wash-sale rule isn’t triggered by “substantially similar” investments.  As a result, index funds are good candidates for tax loss harvesting because there is usually a substantially similar (but not substantially identical) fund that is closely correlated to the fund being sold.  For example, index funds that invest in the same asset class or sector, but that track different indexes, may be very closely correlated, but not regarded as “substantially identical” for tax purposes.[1]

It’s important to recognize that in most cases, tax loss harvesting does not eliminate capital gain taxes but rather defers them.  That’s because the replacement security you buy will have a lower tax basis than the one you sold.  As a result, the tax savings you enjoy today may result in a corresponding increase in taxes tomorrow, if you eventually sell the new security at a gain during your lifetime.[2]  Then again, if the investments you make with your tax savings prove to be profitable in the interim, you’ll come out ahead in the long run.  This is why so many tax advisors are fond of the old saw “A tax deferred is a tax saved”.

Another potential benefit to tax-loss harvesting is that it can potentially defer the taxation of capital gains until the taxpayer is in a lower tax bracket, such as after the investor has retired.  By the same token, tax deferral can backfire if rates go up or the taxpayer’s income unexpectedly increases (a nice problem to have).

It is also important to recognize that if you are not selling your entire position in a security, and you made purchases of that security at different times, then the IRS requires you to identify the specific lot or lots being sold.

2019 has been a banner year for investors, with just about every asset class on track to close 2019 with a profit.  If you want to use tax-loss harvesting to offset some of those gains you need to sell the positions that have built-in losses before December 31^st.  There are also a variety of other legitimate ways to lessen the tax bite on your investments, several of which I discussed in this post.

Michael Jordan advises us to “Always turn a negative situation into a positive situation”.  Tax loss harvesting is one way investors can follow his sage advice.

Thank you for reading,

Andrew J. Willms, JD, LL.M

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[1]IRS Publication 550 discusses when two securities are considered substantially identical.

[2]Investments that are includable in a deceased person’s estate for estate tax purposes receive a basis adjustment for federal income tax purposes even if the decedent’s estate is not large enough to trigger an estate tax.  This adjustment results in an heir’s income tax basis on inherited investments being either “stepped up” or “stepped down” to the property’s fair market value at the date of the decedent’s death.  An exception to this rule is “income in respect of a decedent” (or “IRD”), which is earned income that has not yet been taxed (i.e., retirement accounts, IRAs, annuities, deferred compensation, etc.).  IRD does not receive a basis adjustment when the owner dies.