You may have heard of tax loss harvesting. Some people harvest losses every year, while others do so only when they have taken significant capital gains or have received more income than expected during a given year (perhaps they sold a business, received an inheritance, or collected a sizeable bonus).
Tax loss harvesting occurs when an investor sells an investment at a loss, meaning the investor’s cost basis – the original purchase price adjusted to account for dividends, stock splits, and other factors that may affect the cost of the investment – is higher than the investment’s current market value. For example, if an investor paid $100 for an investment and sold it for $95, he would have harvested a $5 loss. (If the investment sold for $105, the investor would realize a $5 gain.)
How does it work?
When an investor sells an investment that has lost value, she gains an opportunity to reduce the taxes she owes in the current year and, possibly, in future years. In general, losses can be used to reduce the taxes owed on:
Appreciated investments. When an investor realizes a capital gain by selling an appreciated asset, he owes taxes on the gain. Investment losses offset investment gains, eliminating or reducing the capital gains tax owed.1
The length of time an investor owns an investment plays an important role in tax loss harvesting. Short-term losses are losses taken on investments held for less than one year. They may be used to counterbalance short-term gains and then long-term gains. Short-term gains are more expensive than long-term gains because they are taxed as ordinary income.1, 2
Long-term losses, losses taken on investments held for more than one year, offset long-term gains. IRS.com explained the concept of offsetting gains and losses:3
“If your long-term gains are more than your long-term losses, the difference between the two is a net long-term capital gain. If your net long-term capital gain is more than your net short-term capital loss, you have a net capital gain.”
In other words, if there are more gains than losses, the investor will owe capital gains taxes, although the amount owed may be significantly less than it would be otherwise. (This does not apply to investors who are in the 10 or 15 percent tax brackets. Individuals in those brackets currently do not pay taxes on long-term capital gains.)1
Ordinary income. If there are more losses than gains (or there are no gains at all), the extra losses may be used to offset ordinary income. In any tax year, investment losses can offset up to $3,000 of ordinary income ($1,500 if you are married and filing singly).3
Future gains and income. If there are leftover losses once capital gains have been offset and ordinary income limits have been reached, the excess can be deducted from gains or income during the following year.3
Choosing a strategy.
Sometimes, if an investor has been holding onto an investment in the hope it will regain lost value, he doesn’t mind selling it to put the loss to work. Other times, the investment is an important part of the investor’s portfolio, and he wants to keep it. In the latter case, the investor has two options:
1. Sell the investment and buy it back. An investor can sell an investment for a loss and then buy it back, but she has to obey the Wash-Sale Rule. Any investor who sells an investment for a loss cannot purchase the investment, or a substantially similar investment, within 30 days before or after the sale. If they do, the loss is disallowed. Spouses cannot purchase the investment in that time frame either. If the loss is disallowed, it is added to the cost basis of the investment.4
2. Double up and then sell. Since the objective of investing is to buy low and sell high, selling an investment that has lost value may be disagreeable. If an investor prefers to buy low, he can double up on the investment. Basically, that means double the amount of the investment. After waiting 31 days to avoid wash-sale rules, an investor can sell his original holdings and realize the loss (if the investment’s value has remained low).5
During a year like 2015, when markets have suffered some setbacks, tax loss harvesting could prove to be a beneficial way to reduce your tax burden. Before you begin selling investments, it’s imperative to talk with a financial professional or tax advisor so you understand the pros and cons of taking losses.
The opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Investing also involves risk including loss of principal.
This is not intended to be a substitute for specific individualized tax advice. We suggest you discuss your specific tax issues with a qualified tax advisor.
This material was prepared by Peak Advisor Alliance. Peak Advisor Alliance is not affiliated with the named broker/dealer.