While investors welcome market gains, they should not overlook the substantial tax liabilities their positive performing investments may incur when the time comes to sell.
Generally, investors are subject to capital gains tax as high as 37 percent when they sell non-retirement investments, real estate or other appreciating assets. However, it is possible for investors to minimize their exposure to this tax and even reduce their future taxable income when they look for opportunities throughout the year to position their portfolios for losses. This is known as harvesting tax losses.
Tax-loss harvesting is the practice of selling investments or assets that have declined in value in order to create capital losses. Investors may use these losses as credits to offset taxable capital gains or to reduce their taxable income in the current year. For 2023, the federal capital gains tax on long-term investments held for more than one year can be as high as 23.8 percent when taxable income is more than $492,300. Gains on short-term investments and assets held for less than a year are subject to taxation at the ordinary income tax rate, which for tax years through 2025, can be as high as 37 percent, depending on an investor’s income, tax bracket and exposure to the 3.8 percent net investment income tax (NIIT). In some instances, investors may carry forward tax losses that exceed $3,000 in a single tax year into later years, when taxpayers may use them to offset, or reduce, gains and/or taxable income in those years.
Due to this high level of taxation on short-term gains, investors should consider sourcing as much of their taxable losses from short-term investments. Under federal tax laws, short-term losses may be used to offset short-term gains, while long-term losses may be used against gains from long-term investments. However, investors may have an opportunity to apply a portion of losses derived from long-term investments to short-term gains, when those long-term losses exceed long-term gains.
For example, consider an investor who has $3,000 in long-term gains and $4,000 in short-term gains for the 2023 tax year. If the investor sells a long-held asset at a loss of $7,000, he or she may first apply $3,000 of the loss to his or her long-term gain and then apply the excess amount of $4,000 to offset his or her taxable short-term gains or nonqualified dividends. Additionally, even if an investor does not have a taxable gain in the current year, he or she may still use up to $3,000 of a realized loss to reduce his or her ordinary income for the tax year. This is a significant tax-minimizing strategy for which investors may carefully time their sales of losing investments in those years in which they expect their income to rise or their state-level tax liabilities to increase due to a move to a jurisdiction with a high capital gains rate, such as New York, New Jersey and California.
A final benefit of tax-loss harvesting is its ability to potentially help investors preserve their long-term investment mix and financial goals by selling a losing investment and replacing it with a similar asset of comparable risk and return potential. For example, consider that an investment in Mutual Fund Company A that aims to track large company U.S. stocks has gone down. The investor may sell his or her interest in Mutual Fund Company A and purchase an investment from Mutual Fund Company B, which invests in a different manner or different asset class. The investor may book a tax loss from the disposition of Mutual Fund Company A but maintain considerably similar exposure from its investment in Mutual Fund Company B.
However, it is important that investors do not let their pursuit of tax write-offs dictate their investment strategy. There will be times when the sale of a depreciating investment will not make sound financial sense. Similarly, investors must be careful to avoid purchasing the same or a “substantially identical” replacement asset within 30 days of disposing of the original asset and recognizing a loss. The IRS considers these transactions to be wash sales that do not qualify for treatment as deductible capital losses. An example of this would be selling an S&P 500 index fund from one company and buying an S&P 500 index fund from another company.
To avoid this costly mistake, investors should engage the counsel of experienced tax accountants and financial advisors who can provide them with recommendations for appropriate replacement investments that will not trigger the wash-sale rules.
About the author: Todd A. Moll, CFP®, CFA, is a director and chief investment officer with Provenance Wealth Advisor (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with PWA Securities, LLC. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or email@example.com.
Provenance Wealth Advisors (PWA), 200 E. Las Olas Blvd., 19th Floor, Ft. Lauderdale, FL 33301 (954) 712-8888.
Todd A. Moll, CFP®, CFA, is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
Every investor’s situation is unique. You should consider your investment goals, risk tolerance and time horizon before making any investment or withdrawal decision. Investing involves risk and you may incur a profit or loss regardless of the strategy selected.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. Stock market. Direct investment in any index is not possible. Although certain investment products are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, these products may not be able to exactly replicate the performance of the indexes due to expenses and other factors. Asset allocation and diversification do not ensure a profit or guarantee against loss.
Posted on December 19, 2023