It might seem counterintuitive but owning an investment with a loss can be beneficial – at least from a tax perspective. To illustrate, consider the mentality of car ownership for those of us who aren’t “car people.” That is, we don’t care much about make, model, or features; we just a want a vehicle that will get us from point A to point B. If the Honda I drive today breaks down, I’ll replace it with a Toyota tomorrow and expect the same overall performance.
Now imagine that the IRS mails you a coupon to use on this year’s taxes because you sold your broken-down Honda. This process of selling an asset, buying a replacement, and capturing a tax benefit is known as tax loss harvesting.
Tax Loss Harvesting Defined
Tax loss harvesting is the practice of selling an investment at a loss and replacing it with a similar investment. The realized loss becomes a “tax asset” which can be used to offset capital gains and/or income.
Keep in mind, the sold asset isn’t “broken down” like in the analogy above. It’s a fact of investing that every investment goes down at some point, even if our long-run expectation is that it will increase in value. In the same way, the replacement investment is no better than the original investment. The replacement investment should have similar investment characteristics (i.e. asset class, expense ratio, management strategy) such that your overall asset allocation and risk level stays consistent.
By selling an investment at a loss, the IRS allows you to report a capital loss on your taxes. That capital loss can be used to offset capital gains or reduce your reportable income by a certain amount. In other words, the result of effective tax loss harvesting is a tax benefit to you without any change to your investment strategy.
Some Things to Keep in Mind
Tax loss harvesting is usually most effective during volatile markets when asset values fluctuate more often and to a greater degree than usual. Therefore, if you want to employ an effective tax loss harvesting strategy, it is important to have a process for monitoring your investments constantly as these opportunities can appear (and disappear) quickly.
When you buy the replacement investment, you are buying at a price that will effectively lower your cost basis. Since your expectation is that the investment will rise over time, your eventual capital gain will be higher in the future (compared to if you held the original investment). In other words, tax loss harvesting allows you to defer gains, not avoid them completely. Of course, a tax reduction today and the deferral of capital gains is still a significant benefit.
Tax loss harvesting only makes sense in taxable accounts (e.g. trusts, joint accounts, individual accounts). Capital gains and losses are not taxable in retirement accounts such as IRAs and Roth IRAs.
Seaside Wealth Management monitors client portfolios for tax loss harvesting opportunities daily. If you have questions about tax loss harvesting, tax reduction strategies, or financial planning in general, we would be happy to meet with you.