In light of a volatile year of reaching and retreating from record market highs, investors concerned about the tax impact of their realized investment profits may want to consider doing some year-end tax-loss harvesting—a strategy that could reap them a potential tax benefit.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy that potentially lowers the taxable income of investment returns held in taxable accounts. It’s the act of selling an investment at a loss to offset the realized capital gain of selling an investment for a profit or to reduce one’s ordinary taxable income, including income from dividends and interest.
Under current tax law, realized capital losses offset realized capital gains dollar for dollar, and up to $3,000 in excess losses can reduce one’s ordinary taxable income by an equal amount for the tax year. Any losses exceeding $3,000 can be carried forward to offset capital gains or income in future tax years.
The deadline for tax-loss harvesting is Dec. 31, but transaction settlement times vary by broker, so it’s best to complete all trades well in advance of then.
How Does Tax-Loss Harvesting Work?
Investors are taxed on their net capital gains. For example, an investor hypothetically sells shares of Apple (AAPL) for a profit, realizing a $10,000 capital gain. Unfortunately, the investor’s shares of Lululemon Athletica (LULU) haven’t done as well and are down by $5,000 from the purchase price. Selling LULU at a loss would potentially offset the capital gains from selling AAPL at a profit—meaning the investor would only owe taxes on the $5,000 profit instead of $10,000.
In another hypothetical scenario, say the investor’s LULU losses were $13,000. In this case, selling LULU would offset the entire $10,000 capital gain from selling AAPL and, assuming no other capital gains or losses for the year, would allow for the remaining $3,000 loss to offset the investor’s ordinary taxable income.
By harvesting the losses in both scenarios, the investor’s portfolio value remains the same, the proceeds from the sales are available to reinvest in similar or different investments or withdraw, and their tax burden is reduced, likely resulting in a smaller tax bill or possibly increasing their tax refund.
Don’t Wash Away Losses
Investors making tax-loss sales must be mindful not to trigger a “wash sale” if they want to realize the tax benefit of the intended tax-loss harvesting. A wash sale occurs when an investor sells an investment at a loss but then buys the same or a “substantially identical” investment within a 61-day window spanning the 30 days before and after the sale. If a wash sale occurs, the tax loss is disallowed and deferred until the new investment is completely sold.
Who Should Consider Tax-Loss Harvesting?
No matter if an investor has realized short-term capital gains (taxed at their ordinary income tax rate), or long-term capital gains from investments held longer than a year (taxed at a maximum of 20%), harvesting investment losses can be a tax-savvy strategy. That said, which income tax bracket an investor falls in can influence how big a benefit tax-loss harvesting may provide.
To ensure tax-loss harvesting reaps the intended tax benefits, the Illinois CPA Society (ICPAS) recommends speaking with a certified public accountant (CPA). A CPA can detail how tax-loss harvesting at year-end and throughout the calendar year helps investors manage their tax liabilities and make more tax-efficient investments and financial plans. ICPAS’ “Find a CPA” directory connects investors with trusted, strategic tax advisors. Find a CPA at www.icpas.org/findacpa.
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