Tax-Loss Harvesting: Strategizing Around Investment Losses
As an investor, using smart strategies could help you grow your portfolio over time. One strategy that can be used to manage the taxes in your investment portfolio is tax-loss harvesting. The idea behind tax-loss harvesting is selling investments that have decreased in value and using the losses to offset gains from the sale of other investments. While taxes should not be the primary driver of investment decisions, tax-loss harvesting provides an investor an opportunity to potentially reduce their tax bill and possibly increase their after-tax returns.
Jack, an investor, has a long-term position in ABC company stock, which he purchased 30 years ago for $100,000. This is considered Jack's cost basis in ABC. Over the years, the value of Jack’s ABC stock has appreciated to $400,000, which represents an unrealized gain of $300,000 in his ABC position.
Market Value Cost Basis Unrealized Capital Gain
Because of ABC's price appreciation, Jack's position has become four times the size of a normal position in his portfolio. Due to this, Jack believes that his portfolio is under-diversified, meaning that he has too much invested in one company, which could exposure his portfolio to additional risks. Jack believe that by selling some ABC shares, he could reinvest the funds in different companies and sectors that better align his portfolio with his financial goals. However, he has been hesitant to sell some of his ABC shares because of the potential tax associated with selling the shares.
Tax Treatment on the Sale of Stock
If Jack sold some of his shares of ABC, he may have to pay taxes on the transaction. Because Jack has held his ABC stock for over a year, his gain on the sale would be considered a long-term capital gain and would be taxed at his long-term capital gains tax rate, which is 0%, 15%, or 20%, depending on his taxable income and filing status.
Type of Gain
Less than 1 Year
Short-Term Capital Gain
Ordinary Income Tax Rate
1 Year or Longer
Long-Term Capital Gain
Long-Term Capital Gains Tax Rate:
0%, 15%, or 20%. (Depending on your taxable income and filing status.)
Jack may be able to use losses elsewhere in his portfolio to potentially offset the taxes associated with selling some of his shares in ABC company and reduce his overall taxes for the year.
Let’s assume Jack also has an investment in XYZ company in his portfolio. Jack originally purchased shares of XYZ 2 years ago, for $100,000. Since then, his holding in XYZ has decreased in value to $60,000. This decrease in the value of his XYZ holding represents an unrealized capital loss of $40,000. If Jack were to sell his entire holding in XYZ, he would realize a long-term capital loss of $40,000. This long-term capital loss on XYZ could be used against the long-term capital gain realized from the sale of his ABC dollar for dollar, creating a net long-term capital gain. If Jack were to sell $100,000 of ABC stock, as well as his entire $60,000 holding in XYZ, he could offset the $100,000 realized gain on ABC with the $40,000 realized loss from XYZ. This would result in a total net long-term capital gain of $60,000 from the two sales, allowing Jack to reduce the size of the ABC position in his portfolio and potentially reduce the taxes due from the sale of the ABC.
Jack Sells ABC Shares Jack sells XYZ Shares Net Long-Term Capital Gain (long-term capital gain) (long-term capital loss)
Jack’s long-term capital gains (LTCG) rate would then be used to determine the taxes due on the sale. For example if Jack's long-term capital gains rate was 15%, then the tax attributable to his net long-term capital gain would be $9,000.
Net LTCG LTCG Tax Rate LTCG Tax
In the previous example, if Jack had only sold $100,000 of his ABC holding, and his capital gains rate was 15%, he would have a long-term capital gains tax of $15,000. However, because Jack also sold his XYZ stock, he was able to reduce his long-term capital gains tax to $9,000, resulting in a tax savings of $6,000 for the tax year.
Avoiding a Wash Sale
Its important to be aware of the “wash-sale” rule when attempting to use losses to offset gains in an investment account. The wash-sale rule is an IRS regulation that prevents a taxpayer from taking a tax deduction for a loss on a security when an individual sells or trades a security at a loss, and within 30 days before or after the sale, buys the same or a substantially identical security. For example, if Jack decided to repurchase XYZ within 30 days before or after he sold it, he could not use the realized loss against the realized gain on the sale of ABC. This also applies to purchasing and selling the same position in all outside investment accounts owned by the taxpayer. If Jack chose to reinvest the proceeds of the sale, he would have to invest in a different company or substantially different security, or wait 31 days following the sale before repurchasing XYZ in order to avoid the wash-sale rule.
While tax-loss harvesting is a great strategy to potentially reduce taxes in an investment account, its important to remember that investment decisions should not be based on taxes alone. When making any investment decision, the primary consideration should be how the investment fits into the investors overall long-term financial plan.
Disclaimer: Before implementing any tax related strategies, it is important to consult a qualified tax professional. Often times, individuals utilize a tax professional as well as a trusted financial planner to collaborate on effective strategies for their particular situation. The information above is for education purposes only and is not considered tax advice. For advice pertaining to your specific situation, please consult a qualified tax professional.
For more information on capital gains and losses, please visit the IRS's website and review Chapter 4 of IRS publication 544: https://www.irs.gov/publications/p544
Portfolio Manager, Crescent Sterling Ltd.
Brandon is a Portfolio Manager at Crescent Sterling Ltd.
He works with individuals and families to help them plan
for their long-term financial goals.