Turning Lemons into Lemonade: Tax-Loss Harvesting

Turning Lemons into Lemonade: Tax-Loss Harvesting
For many taxpayers, tax-loss harvesting is the single most important strategy for reducing taxes now and in the future.
by James Lange, CPA, Matt Schwartz and Steven T. Kohman, CPA, CSEP, CSRP

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Appropriate tax planning can’t restore your investment losses, but offsetting investment losses with investment gains can reduce your taxes and save you money. For many readers, tax- loss harvesting is the single most important strategy for reducing taxes now and in the future. Used effectively, tax-loss harvesting strategies can save you taxes and help you diversify your portfolio in ways you may not have considered.

Financial planners and advisors who understand and apply these principles really do offer “value added service.” If your financial planner has not talked with you about this strategy, you would be wise to bring it up. But motivated do-it-yourselfers should not be left in the dark. Both camps will benefit from reading the following analysis.

Understanding the Ground Rules

Rule 1:      On the first pass of pitting gains against losses, the IRS forces you to match short-term gains against short-term losses including short-term carryover losses and long-term gains against long-term losses and carryovers. 
 
Rule 2:      Then, the net short-term results are weighed against the net long-term results. If the net result is a gain, it will be taxed as short-term, long-term or a combination of the two if they are both gains.

If you can avoid it, you do not want to end up with short-term taxable gains because you failed to sell, prior to year-end, securities that would have created a loss to offset these short-term gains.  Short-term gains are taxed at ordinary income rates that are as high as 35% in 2007.  Ideally, you want to generate losses because you can deduct up to $3,000 per year of losses against ordinary income. These are important concepts to keep in mind as they are factors that recur in most scenarios evaluating tax-loss harvesting.

Let’s Look at an Example

Rita is 68 years old and has been investing in the market for many years. With retirement approaching, she has decided to take a more active part in monitoring her holdings. She figures it is in her best interest to be informed—especially when it comes to saving taxes.

In looking over her most recent statement from her broker, she sees that one of her investments that she bought  for $20,000 is now worth $30,000, and there is no adjustment to the basis.  That’s a winner!

However, she also notices that one she bought it for $20,000 is now worth $10,000. That’s a loser.

Rita’s federal tax rate is 25% and both holdings qualify as long-term investments.

Question: What should Rita do to maximize her tax savings? Let’s sort through some options. There is perhaps no one best answer. Rita has to consider her big picture and long-term objectives.

Option: Dump the $10,000 loser and take the annual $3,000 deduction against her ordinary income each year until the loss has been fully deducted.  

At Rita’s 25% tax rate, that will translate into an immediate federal tax saving of $750, which tops doing nothing. Knowing she will pay $750 less in taxes, she can afford to reinvest $10,750 (the $10,000 sale price of the investment plus the $750 tax savings; subject to limitations). She will also be able to carry the loss forward and continue to realize tax savings over several years.

[Note: The impact on your state taxes will vary depending on the state’s regulations; you may or may not be able to carryover the losses to subsequent years. For example in Pennsylvania, you would permanently lose your deduction for the capital loss.]

Question: But, Rita likes the loser, and she thinks it has the potential to recover. What should she do now?

Option: Sell the loser and then, subject to the wash rules*, buy it, or something similar to it, back.

After repurchasing the loser (or a similar type of investment) for $10,000, assume its value climbs back to $20,000.  Except for transactions fees, Rita will have had:

  • The benefit of the $750 tax savings each year for the next three years and $250 tax savings in the fourth year generating total tax savings of $2,500 from deducting the loss.  Even if she sells the investment later for $20,000 and pays an additional $1,500 in taxes on the $10,000 capital gain, she is still $1,000 ahead through the tax savings of deducting the original $10,000 loss against her ordinary income.
  • the additional opportunity to hold onto the investment until her death so that the beneficiaries will inherit the investment with a full step-up in basis which would virtually avoid the capital gains tax altogether.
  • the advantage of the growth of the investment.
  • maintained the integrity of her portfolio.

While it might seem counter intuitive, even if the losing investments you currently hold recovered in value, it still is a better strategy to sell them at a loss and reinvest the proceeds in similar investments. (Be careful to avoid a wash sale, i.e., buying the same security within 30 days of the time you sell the shares—the tax rules will disallow the loss.)

Question: Rita is also concerned that her portfolio is inadequately diversified, she would like to see if there is a good way to begin rebalancing her portfolio. Is there a way for her to use her current situation to her advantage?

Option: Sell the winner and dump the loser this year.

As both of Rita’s investments qualify as long-term holdings, she can sell both the winner and the loser, offset the losses ($10,000 long-term capital gain, $10,000 long-term capital loss) and owe no taxes on the transaction. She now has $30,000 to purchase other investments that can go toward rebalancing her portfolio.

For someone who is very heavily positioned in a particular stock or mutual fund in a particular sector (like a large cap fund), this strategy can be particularly effective. Perhaps, you have avoided selling it for years because you are too cheap to pay the capital gains tax. With knowledge of this strategy, you offset your losses against your gains and lo and behold, you just opened up your window to diversification. Then, you repurchase the winner and the loser or whatever you like, and your basis will be your purchase price.

Question: Rita’s instinct is to follow through with selling both the winner and the loser before the year end, but she has one other piece of information that she needs to add to the mix. She knows that in January of 2008, she will be receiving a nice short-term profit on one of her stocks—she thinks it will be around $10,000. Is there a better long-term strategy that she can use to maximize her tax savings?

By thinking ahead, Rita can really take advantage of the adage, the best losses are well timed losses. As this example will demonstrate, it may not always be the best decision to recognize losses in the current year.

If Rita sells the winner and loser this year, she will not pay taxes this year, but she will be faced with a short-term capital gain next year when she realizes the nice short-term profit—which she would like to do since she is thinking about a European vacation next year. Unfortunately, the short-term capital gain would be taxed at Rita’s ordinary tax rate of 25% which would cost her $2,500.

If Rita decided to go ahead and sell her winner, because she still would like to diversify her holdings, she will owe $1,500 in taxes this year (15% capital gains tax on the $10,000). If she then decides to hold on to loser till next year and then sell it, she can use the long-term capital loss to offset her short-term capital gain. By timing her losses to offset her short-term gains in 2007, she would avoid having to pay $2,500 in taxes next year. Her net tax saving would be $1,000 ($2,500 - $1,500).

Suffice it to say that conceptually this strategy can be applied to situations where larger numbers are involved and also where there are excess losses. Remember, if you have excess losses, you can still deduct up to $3,000 against your ordinary income.

In Summary

Harvesting your investment losses can reduce your capital gain income to zero and give you a bonus of a $3,000 ordinary income reduction each year.  It’s a great way to increase the after-tax rate of return on your portfolio without the risks of active trading.  In combination with a good asset allocation and reallocation strategy, you can add value to your investment portfolio without increasing your investment risk.

Finally, between now and year end is your last chance to review your portfolio to see if you can benefit from some strategic tax-loss harvesting. If you are still holding stocks with both unrealized gains and losses, you should consider selling enough to generate some losses up to at least $3,000. Recognizing more losses to offset other gains may also be advisable.

Selling investments to realize net losses in excess of $3,000 can be a good idea too. The losses will carry over to future years when future gains can be reduced. Plus, with the carryover, you can continue to take advantage of the $3,000 per year that can be deducted from ordinary income. The loss carryover can also eliminate future short-term and long-term capital gains and will free you from subsequently sticking with investments only because of the holding period.

What to do next? Turn lemons into lemonade…

If you are an avid do-it-yourselfer, then get out your records and begin mapping out a strategy.

If you find all of this too overwhelming, and yet you see the inherent value of the advice, perhaps you would be well advised to consult with your financial advisor and your tax advisor. 

*Be careful to avoid a wash sale, i.e., buying the same security back within 30 days before or after you sell the shares.  Tax rules will disallow the loss. Keep in mind, however, that with all the stock and mutual fund choices, there is probably a similar investment available for you to park your money in for 30 days. This may be a better strategy than keeping funds in cash for 30 days waiting to repurchase the same stock since the market or the sector may move up significantly in 30 days. 

Thank you for taking the time to read this article and we wish you much success in your ongoing efforts to maximize your tax savings.

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

 

James Lange, CPA

Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania.  He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again.  He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger's Retirement Reports and The Tax Adviser (AICPA).  Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.

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