How tax harvesting reduces what you owe on gains
Seeking ways to improve after tax outcomes is a core part of our wealth management and family office services. One common approach is tax harvesting. This article explains how tax harvesting reduces what you owe on gains, and where it falls short.
How tax harvesting reduces what you owe on gains
The math is simple. In accounting terms, the goal is to push this formula toward a net loss:
Net gain or net loss = (long term capital gains less long term capital losses) + (short term capital gains less short term capital losses).
In other words, we realize losses in the portfolio to offset gains the portfolio realized during the year. As a result, the tax owed on those gains may fall or disappear. Those gains may come from selling positions or from capital gains distributions by mutual funds.
However, harvesting usually defers tax rather than erasing it. The replacement holding typically has a lower cost basis, so future taxable gains may be larger. In practice, the strategy also applies only to taxable accounts and can add trading costs.
In addition, the IRS lets most taxpayers deduct up to $3,000 of net capital losses per year against ordinary income. For married taxpayers filing separately, the limit is $1,500, according to IRS Topic No. 409.
Carryover losses
If losses exceed gains in a given year, the excess becomes a carryover loss. For individuals, federal rules let these losses carry forward to offset future gains, plus up to $3,000 of ordinary income each year. Meanwhile, taxpayers generally owe tax on realized gains for the year they realize them.
For example, The New York Times reported in 2016 that Donald Trump declared a $916 million loss on his 1995 tax returns. The Times tied the loss to casinos, an airline, and Manhattan properties. According to the Times, that loss could have let him legally avoid federal income taxes for up to 18 years. Of course, the Times described a net operating loss, which follows different rules than the capital loss carryovers most investors use.
Do not let the tax tail wag the portfolio
In our opinion, tax savings should not drive investment decisions. Instead, the portfolio should stay aligned with its specific investment objectives. Above all, coordinate this strategy with your CPA and other advisers, since results depend on your full tax picture.
Understanding how tax harvesting reduces what you owe on gains helps you set realistic expectations. First, review realized gains and losses as the year progresses. Next, weigh any potential loss sale against your long term allocation. In addition, consider whether a replacement holding keeps your intended market exposure. Finally, keep clear records of each trade so your CPA can report it accurately. In practice, market declines can create harvesting opportunities at any point in the year, not only in December.
Watch the wash sale rule
Advisers should consider several IRS rules when making portfolio changes. The most prominent is the wash sale rule, which discourages selling at a loss simply to claim a tax benefit. A wash sale occurs when you sell a security at a loss and buy a substantially identical one. The window runs 30 days before or after the sale. As a result, the IRS generally disallows the loss and adds it to the new position’s cost basis.
For instance, as a hypothetical illustration, an investor might sell a fund tracking the S&P 500 and buy a fund tracking the Dow Jones Industrial Average. The two indexes often move similarly but hold different stocks. However, the IRS has not clearly defined ‘substantially identical,’ and the replacement may perform differently. Therefore, confirm any swap with a tax professional first.
This article is for educational purposes only and does not constitute tax, legal, or investment advice. Tax rules can change, and individual results vary.
