Experiencing extreme downside volatility can feel like life’s handing you a whole lot of lemons, even if it is a normal occurrence. However, these periods can also afford us the opportunity to make lemonade!
Capturing tax losses during periods of market declines can lower an investor’s tax liability while also allowing an investor to build a more efficient portfolio. Managing taxes within a diversified portfolio is just as important as managing the investments themselves.
Not every advisor does this, but for high income/high-net-worth investors it’s a necessity. After all, these investors are often subject to the highest tax rates. Remember the old adage, it’s not what you make that counts, but what you keep.
As we explore tax loss harvesting today, I set to answer a question you may be asking as you begin to gather your tax documents: “With my portfolio showing a gain for 2020, why might I receive a 1099 tax form showing a capital loss?”
What is Tax-Loss Harvesting?
Tax-loss harvesting is the process of selling an investment that has dropped in value below an investor’s cost basis. The investor reinvests the sale proceeds into a different security that still meets their overall investment risk profile and asset allocation strategy. The recognized loss is then used to reduce realized taxable gains in other parts of the overall portfolio.
For this discussion it’s important to understand the difference between capital gains and capital losses. A capital gain is the profit an investor realizes when selling an investment at a higher price than originally paid. A capital loss is the opposite, selling an investment at a lower price than originally paid.
An investor’s cost basis is the price paid for the investment.
Short-term capital gains are realized for an investment held for one year or less. These gains are taxed at ordinary income tax rates.
Long-term capital gains are realized for an investment held greater than one year. Long-term capital gains have their own tax brackets (shown below) which are more favorable than ordinary income tax rates.
Taxation is based on the net of gains realized in a certain year. Short-term losses are first netted against short-term gains. Long-term losses are netted against long-term gains.
An investor has owned Coca Cola for longer than one year and has a cost basis of $10,000. Because of market volatility, Coca Cola has dropped to a current value of $7,000. The investor sells Coca Cola and realizes a long-term capital loss of $3,000. They then purchase $7,000 of Pepsi, with a similar risk profile that still fits within their model asset allocation, but which is not “substantially identical” to Coca Cola.
The market recovers and by the end of the year Pepsi is now worth $12,000.
What has the investor gained?
An improved tax situation while keeping their portfolio aligned with their risk/reward profile!
In this case, the investor made a profit of $2,000 while holding these two securities but has captured a loss for tax purposes of $3,000.
As mentioned above, this investor could:
1. Use this loss to offset other realized gains in the portfolio in the current year, then
2. Deduct remaining losses against ordinary income up to $3,000, then
3. Carry any remaining losses forward to a future year.
Let’s Talk Taxes
In addition to the Federal Capital Gains Rates, there are two other taxes that apply. First, is the net investment income tax (NIIT) which is applied at a rate of 3.8%. This is on top of the capital gains rate for single filers with incomes above $200,000 and married filing jointly of $250,000.
The second is state income tax. Here in California, there are not separate tax rates for income and capital gains. Whatever you recognize in capital gains is added to your ordinary income. So, a high-income California resident hitting all the highest brackets, would pay 37.1% on long-term capital gains.
Benefits of Tax Loss Harvesting
1. Periodic portfolio rebalancing has been proven to reduce a portfolios overall risk while improving returns over time. Rebalancing means selling something that has done well (realizing capital gains) and buying something that has not done as well. Tax loss harvesting can help take the bite out of this disciplined strategy.
2. Asset allocation models are created with the goal of maximizing return for a given level of risk over a full market cycle. Asset classes that make up a model portfolio will display risk and return characteristics that change over time. An optimized portfolio must change as well. This means trading, and thus possibly realizing taxable gains. Proactive tax loss harvesting can help mitigate the tax consequences that come from keeping your portfolio in line with your goals.
3. Long-term holdings with large, embedded gains are often held in portfolio longer than desired solely to avoid taxes. Perhaps the holding is no longer expected to perform, or it’s a fund where better execution and lower fees exist elsewhere. Tax loss harvesting can provide the tax ammo needed to divest of these holdings in order to optimize the portfolio.
A Word of Caution
The Wash Sale Rule
A loss can be disallowed if the same security or “substantially identical” security is purchased within 30 days before or after the sale.
However, the IRS has not given a definition of “substantially identical” security. Selling and buying the same exact stock or a fund which holds the exact same underlying securities would be substantially identical. However, with the wide availability of mutual funds and ETFs providing exposure to a wide range of asset classes and investment styles, it’s possible to take advantage of tax loss harvesting while maintaining a portfolio’s risk/return characteristics.
Converting Long-Term Treatment to Short-Term
There is a risk that by harvesting a long-term loss and purchasing a new security, you may actually pay more in tax. This could occur if you sold the replacement security within one year. This gain would receive short-term ordinary income tax treatment instead of the original long-term treatment. It’s not always possible to avoid this, particularly if you require emergency access to your capital within that first year, but it’s something to be aware of.
It’s important to note that tax loss harvesting only works in taxable accounts. Thus, qualified retirement accounts like IRAs and 401(k)s are tax-deferred so no benefit is conferred through this strategy.
We are fond of saying, “Don’t let the tax tail wag the portfolio dog.” This means you shouldn’t make portfolio decisions strictly from a tax standpoint. However, systematically looking for harvesting opportunities gives an investor the chance to make changes that maximize his or her portfolio, while possible reducing tax liabilities significantly.
An investment strategy that is tightly coordinated with tax strategy allows you flexibility and efficiency. This is the reason we ask our clients annually for a copy of their tax return.
With tax loss harvesting, you can keep more of what you earn, making lemonade out of lemons!
Please reach out to us and your tax advisor for specific questions related to your individual situation.