If you own an asset like property or stock and that asset declines in value compared to the price you paid for it, when you sell that depreciated asset you get to use that loss to offset gains.
A simple example. You buy Apple stock at $120/share. Apple stock loses 20% and the price falls to $96. You're upset so you sell your share. While it's true you've locked in your loss, the good news is that the $24 decline from your original price paid can be used to offset capital gains or even ordinary income.
Continuing this example, let's say you sold Microsoft stock earlier in the year for, coincidentally, a $24 gain. Your $24 Apple loss offsets your $24 Microsoft gain. In other words, the 15% capital gain tax you would've paid on the Microsoft gain was $3.60 ($24 x 0.15), so by using the Apple loss against the Microsoft gain, you saved yourself $3.60 in taxes.
ENTER: THE FINANCIAL ADVISOR
Beware, I'm about to put on my cynicism hat for a brief moment.
Financial advisors often tell prospects how sophisticated their investment acumen is. An easy story to sell is that of Tax Loss Harvesting (TLH).
"I can capture losses for you and reduce your taxable income if you hire me"
Sounds great, right?
Like many financial concepts financial advisors explain, often the benefit is highlighted without full context, including potential negative consequences. The rest of this post details how a complete TLH strategy needs to examined.
WHAT REALLY HAPPENS
Using the original Apple stock example, let's continue it to its natural conclusion. While it's true you enjoyed a current tax benefit from the TLH, what do you do with the $96 in cash (proceeds from selling Apple stock) in your account?
You really have two main options.
Option #1 is to hold it in cash for the next 30 days to avoid the WASH SALE rule and you can buy Apple stock again.
Option #2 is to buy a different investment and either hold it for the long term or sell it after your 30-day waiting period and then repurchase Apple.
The issue with Option #1 is the opportunity cost of the market appreciating while you're sitting in cash. This scenario could effectively wipe out the TLH tax benefit and then some, i.e., you missed out.
The problem with Option #2 is what happens when you buy that replacement investment and it appreciates? When you go to sell it after your 30 day waiting period expires, now you have to pay short term capital gain taxes, which mirror ordinary income tax rates (based on our marginal tax bracket system).
If that temporary investment replacing Apple is ultimately sold once it climbs back up to the $120/share within a calendar year's time, it will trigger a short term capital gain and effectively make the whole transaction worth $0.
The simple concept in my Apple example is that all you're doing is lowering your cost basis (your original price paid) and creating an even bigger gain for yourself at some point down the road.
You would've been better off doing nothing as it would've saved you the mental bandwidth of trading stocks as well as reporting the transaction on your taxes.
WHEN TLH CAN BE BENEFICIAL
Imagine a scenario where you TLH and recognize that $24 capital loss on the Apple stock. You replace Apple with Microsoft and decide that you're going to hold Microsoft for at least a full year so any gains shift from short term (< 1 year) to long term (> 1 year).
Because you claim the $24 capital loss on your tax return and you're in the 22% marginal tax bracket, you receive a $5.28 tax benefit.
If you were diligent enough to take that $5.28 and invest it and it grew at a modest 6%, then you just found a sneaky (efficient) way to increase your net worth.
The other scenario is what's referred to as tax arbitrage. Here, if you can realize enough losses in your portfolio to offset 100% of the gains, then you're allowed to use that loss to offset taxable income elsewhere on your return, such as employment or Required Minimum Distributions (RMDs).
Assuming you're in the 22% marginal tax bracket, for every $1,000 in capital losses you recognize, you save yourself $220 on your tax bill. The bigger the loss, the bigger the tax benefit on recognized losses.
For example, if you claim $30,000 in losses and are in the 22% tax bracket, that's $6,600 in tax savings!
The arbitrage piece comes into play because you've captured a tax benefit that offsets income at your marginal 22% bracket, and assuming you repurchased the same investment after your 30-day wash sale waiting period, then when you sell it down the road, you only pay 15% capital gains assuming you hold it longer than 1 year.
The difference between the 22% tax benefit and the ensuing 15% tax cost is the arbitrage that can generate additional after-tax return for you.
MORE COMMON TLH STRATEGIES
Not everybody is going to be as responsible or as dedicated as the two examples in the last section.
Here are 3 scenarios when it might make sense to TLH.
You own an appreciated, concentrated stock position outside of a retirement account such as a 401(k) that you want to unwind. Here, you should be looking for any capital losses in your taxable portfolio to offset the gains from selling your appreciated, concentrated stock. An investor loaded up with stock options is an ideal candidate for this strategy.
You need to sell investments to raise cash for income purposes. In this scenario, hunting for losses to offset gains helps keep your taxes in check. This is common for retirees with at least a moderate degree of reliance on their investments to produce income.
You are a few years away from retirement and expect your income to significantly decline once retired. It's not that uncommon for someone making $100,000+ per year to need much less than that to live on once retired. If the retiree's tax status is married filing jointly and if they can keep their income below $80,000, then they pay a fantastic 0% on long term capital gains.
HOW WE APPROACH THL
First, it has to make sense. Unless a client fits into one of those 3 scenarios above, TLH is really a roll of the dice and can introduce unnecessary complexity. Many of our clients don't fit neatly into one of those scenarios, so TLH is practiced with only select clients.
Second, for clients where loss harvesting makes sense, we look for TLH opportunities throughout the entire year. Most financial advisors only check for TLH opportunities in December, if at all. In fact, most financial advisors outsource their client assets to a 3rd party who couldn't care less about getting the client a tax benefit. It's too much extra work! In order to capture losses, you have to be ready at all times. We leverage sophisticated software that produces a weekly report for clients we've included in our TLH protocol.
Third, we track cumulative gains vs. losses in real-time. At any point throughout the year, our software shows us the total amount of capital gains vs. losses as well as whether those gains/losses are short term versus long term. Our technology nets out the difference to give us an accurate picture of what we've done in every taxable account so far that year.
TLH can provide a benefit, but that benefit is often overstated in the financial advisor community. To recognize an actual benefit, an investor must be vigilant at all times and then have the patience to stick with the replacement investment used in lieu of the investment that was TLH'd.
The optimal approach for most investors is to not just think about harvesting losses but to think about harvesting gains as well. This means that when an investment appreciates, it should be examined from a rebalancing standpoint. Trim some of those gains and reinvest them elsewhere in the portfolio. This helps keep capital gains in check as well as maintains the integrity of a target asset allocation.
If you're not sure how to TLH or if you even should be, reach out to us. We'll help you understand your situation whether you work with us already or are still thinking about hiring us.