Tax harvesting and the IRS rules that shape it
At Activest, looking for ways to improve after tax outcomes is part of our wealth management and family office services. This article explains tax harvesting and the IRS rules that shape it, for educational purposes only.
Tax harvesting is a common strategy that US tax law permits for managing taxes on investment gains. However, it does not suit every investor, and results depend on individual circumstances.
How the arithmetic works
In accounting terms, the goal is for the following formula to produce 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, an adviser may sell positions at a loss to offset gains realized during the year. As a result, the investor may reduce or eliminate the tax owed on those gains. Those gains can come from sales of positions or from mutual fund distributions passed through to the portfolio.
Of course, harvesting often defers tax rather than eliminating it. For example, a lower cost basis on the replacement can mean a larger taxable gain at a later sale.
In addition, taxpayers may deduct up to $3,000 of net capital losses against ordinary income (IRS Topic No. 409). The limit is $1,500 for married taxpayers filing separately.
Carryover losses
If losses exceed gains and the deduction limit in a given year, the unused amount carries forward. Individuals can generally use these carryover losses against future gains. Meanwhile, tax on realized gains is due for the year of the sale. In practice, tracking these carryovers each year helps the investor use them fully.
A widely reported example involves Donald Trump. According to The New York Times (2016), his 1995 tax return showed a loss of about $916 million. That loss reportedly stemmed from casinos, an airline business and Manhattan real estate. The Times said the loss could have offset income for up to 18 years. In practice, the paper said, that could have meant avoiding up to about $50 million a year in federal income taxes. Note, however, that this was a net operating loss, which follows different rules than individual capital loss carryovers.
Why the portfolio comes first
From an investment standpoint, the tax incentive should never override portfolio quality. Instead, the firm keeps each portfolio aligned with its specific investment objectives. Trading costs and market moves while out of a position can also reduce any benefit. Therefore, we coordinate this strategy with the client’s CPA and other advisers.
Next, the adviser reviews which positions carry unrealized losses and whether selling them still fits the plan. For example, a small loss may not justify the trading costs involved. Finally, the family should document each sale and its replacement. Clear records help the CPA report every transaction accurately at tax time.
Wash sales, tax harvesting and the IRS rules that shape it
Advisers must consider several IRS rules when changing a portfolio. Above all, the wash sale rule exists to discourage selling at a loss purely to claim a tax benefit. A wash sale occurs when you sell at a loss and repurchase too soon (IRS Publication 550). Specifically, buying the same or a substantially identical security within 30 days before or after the sale triggers it. As a result, the IRS disallows the loss for now and adds it to the new position’s basis.
For instance, a hypothetical investor might sell an S&P 500 fund at a loss and buy a Dow Jones fund. The two indexes often move similarly, but they differ in composition. However, the IRS has not precisely defined “substantially identical,” and the replacement may perform differently. This example is not a recommendation. Your CPA can explain how tax harvesting and the IRS rules that shape it apply to you.
