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.
Under tax reform, 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 capital gains 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 2020, 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 $425,800. 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 investors 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 the 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 investment. 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 2020 tax year. If the investors 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 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 tracks 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, an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
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