Tax Loss Harvesting
Tax loss harvesting, is a strategy which can be implemented by taxpayers when they suffer losses in the markets. The goal of the strategy is to increase returns by accelerating losses and deferring gains. However, the strategy needs to be executed correctly to be successful.
Example:
You invest $10,000 in a stock which proceeds to lose 50% of its value. You now have an investment worth $5,000 and a cost basis of $10,000. i.e., you have an unrealized loss of $5,000.
Step 1. Sell the investment
Step 2. Purchase a comparable investment that will not trigger the wash sale rule*
By selling the investment at a loss you get to deduct the loss on your tax return in the current tax year. Which will result in either a larger refund or less taxes owed. The additional funds that you now have at your disposal can then be reinvested and grow over time.
Additionally, by purchasing a similar investment with the proceeds from the sale, you will have essentially remained in the same economic position you were in before the sale. i.e., instead of having a $5,000 investment in the stock you originally purchased, you now have a comparable investment also worth $5,000. Because you invested in a comparable investment, if the original stock later recovers, ideally the new investment should also recover.
*The wash sale rule states that a loss will be disallowed in the event that you sell an investment and then buy back the same, or a substantially identical investment 30 days before or after the sale.
Figure 1. Before and after executing tax loss harvesting on a $10,000 investment that dropped to $5,000
Tax Deferral Not Avoidance
It is important to note that when you implement tax loss harvesting, although you get to claim a loss in the current year, the basis in your investment also decreases by the same amount. In the example above, the original investment with a $10,000 basis was replaced by an investment with a $5,000 basis.
Therefore, tax loss harvesting is a means of deferring taxes. It does not avoid taxes. Accordingly, when the investment is eventually sold there will be more taxes owed due to a larger gain or a smaller loss. For that reason, it is important to consider your current and expected future tax brackets before attempting tax loss harvesting.
What can go wrong?
Purchasing a stock that does not closely track the initial investment, could result in less returns than had you not sold in the first place.
Accidentally triggering the wash sale rule and having your loss disallowed.
Claiming the tax loss in a lower tax bracket than the year when you report the corresponding gain.
The subject matter in this communication is educational only and provided with the understanding that we are not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
