Buy low, sell high. It’s probably the most famous investing adage that most people have heard. If you don’t know anything about finance, you at least know that, right? It’s the first thing you were ever told about investing in the stock market, so why would professional investment managers intentionally sell stocks at a loss? Inherently, selling securities at a loss seems counterintuitive. Just like we said above, “Buy low, sell high”, right? Yes, that is right…most of the time.
Fortunately for those who are disciplined enough to remain invested through times when the market is generating short-term losses, the IRS incentivizes us to sell those securities that are at a loss in certain situations.
Tax-loss harvesting is the practice of selling securities that are at a loss so that you can use those losses to offset realized gains and ordinary income to save taxes. That was a pretty confusing sentence, so here’s an example:
Tax-Loss Harvesting Example
Let’s say that you purchased 1 share of Amazon on September 4, 2018 for the closing price of $2,039.51. Then, you sold that same share on December 10, 2018 at the closing price of $1,641.03. You could then use this short-term capital loss of $398.48 to offset short-term capital gains that you realize within the year and potentially other taxable income to help to reduce your taxes.
So, if you sold a stock (or mutual fund or ETF) earlier in the year that you had held for a couple of months at a gain of $500, you could use your loss of $398.48 to offset the gain and you’d only be taxed on the difference of $101.52.
What if you had more losses in a year than you had gains in a year? As of 2018, $3,000 of loss may be carried forward to offset taxable income on future tax returns. For example, if you had losses of $1,000 in 2018 and gains of $500, then you would not have to pay any taxes on those gains and you would be able to carry over the extra $500 of losses to 2019. In 2019, you would be allowed to offset the $500 of carried forward losses against taxable income.
Please keep in mind that there are limits to the amount of tax benefits that you can receive from this strategy so if you’re interested in exploring it, then you should consult with a financial planner and/or tax accountant.
Taxable Account Only
The strategy of tax-loss harvesting allows you to sell securities that you own in a taxable account at a loss and receive the tax benefits described above. However, this strategy doesn’t work for securities that you own within a tax-deferred account such as an IRA or 401(k). Since short-term capital gains are taxed at ordinary income rates (compared to the lower tax rates for long-term capital gains), tax-loss harvesting is a strategy that’s often implemented to help offset the increased taxes that you’d normally have to pay on those gains.
Watch Out For A Wash Sale
Once you sell your security at a loss, you may consider buying it back because you believe in it’s long-term prospects and you want to maintain your portfolio’s desired allocation. Be careful, though, as your tax deduction will be disallowed by the IRS if you purchase the same security or a “substantially identical” security to the one you sold at a loss within 30 days before or after the sale. This is called a “wash sale”.
Wash sales can get a bit tricky and it’s worth doing more research into this to make sure that you don’t run afoul of the rules. In the example above, after selling Amazon at a loss you could then purchase another US equity to help fill out your portfolio. However, you wouldn’t want to purchase back Amazon as you would violate these rules. The same goes for “substantially identical” mutual funds and ETFs if you were to sell one of these types of securities at a loss.
There are many more rules around wash sales and what happens when you’re in violation of the wash sale rules, but that’s a topic for your tax accountant. Just remember that the wash sale period consists of 30 days before you sell the security until 30 days after you sell the security. Don’t purchase a “substantially identical” security within that time frame and you shouldn’t have to worry.
Conclusion
Typically, tax-loss harvesting is a strategy that’s executed towards the end of the year. Although, it can be taken advantage of anytime throughout the year when you have a loss within a taxable account. The US equity markets have experienced some losses since the beginning of this month, which may mean that you can take advantage of tax-loss harvesting in your taxable account if you’ve been saving to the account on a consistent basis. If it aligns with your investment strategy, then you may be able to practice tax-loss harvesting, reset the basis in your investment, and make the best of the situation at hand.
