January 30, 2023
by Barry Brindise, Financial Planning Director
Tax Loss Harvesting
When it comes to investing in any type of asset, experiencing losses can be very frustrating. However, there is an investing strategy called, “Tax Loss Harvesting” or “Tax Loss Selling,” which can be used to take those losses and use them to offset other gains in your portfolio and thus reduce your overall tax liability (all while maintaining the target asset allocation). Tax Loss Harvesting can also be used to take a net loss to your tax return without attempting to offset other capital gains. In this case, these losses help offset ordinary income and you are limited to up to $3,000 per year and amounts greater than this can be carried forward to future tax years.
At Brightwater we most typically apply Tax Loss Harvesting in the context of offsetting portfolio gains that may result from portfolio rebalancing activities. For example, if your target allocation between equities and fixed income or bonds is 50% and market returns push your actual equity allocation closer to 55%, then some rebalancing may be necessary. This rebalancing could result in the generation of short-term (assets held a year or less) or long-term (assets held longer than a year) capital gains. Tax Loss Harvesting can reduce or help offset the impact of those gains and lower your tax bill while helping to maintain your target equity allocation.
When selling any asset, we need to be conscious of IRS “Wash Sale” rules. These rules apply to all sales of exchange listed securities. For example, if you sell stock XYZ for a loss, you cannot repurchase it for at least 30 days or your loss and related tax deduction would be disallowed. Wash Sale rules apply to what the IRS calls, “Substantially Identical Securities.” To extend our example, “substantially identical” would include stock options in XYZ stock or an alternative class of XYZ stock like “preferred” or “common” issues. In addition, you cannot skirt the Wash Sale rules by repurchasing XYZ in a legally different type of account. As an example, you cannot sell XYZ in your taxable brokerage account and then repurchase it in an IRA account in fewer than 31 days.
Client Investment Plans at Brightwater Advisory will typically hold a variety of assets. In addition to mutual funds, bonds, CDs, cash, and individual stocks, one of the asset classes we use to build equity positions are called Exchange Traded Funds (ETFs). Morningstar Research defines ETFs as, “hybrid investment vehicles that can offer relatively low-cost and tax-efficient exposure to a variety of asset classes and investment strategies. Like traditional mutual funds, most ETFs invest in a diversified portfolio of stocks and bonds. Unlike traditional mutual funds, ETFs trade on a stock exchange.”
There are over 5,000 ETFs worldwide and the more popular, lower cost funds, will hold a basket of equities to resemble a sector (like home builders or healthcare) or an index like the S&P500 or the Dow Jones Industrial Average. To date, the IRS has not fully defined “substantially identical securities” in the context of diversified ETFs. As a result, the large variety of ETF alternatives lend themselves very well to Tax Loss Harvesting without triggering the Wash Sale rules. For example, an investor entering the end of the year with $30,000 in realized capital gains could evaluate unrealized losses in their portfolio for Tax Loss Harvesting. Let’s assume they have a position in the Vanguard Energy Index Fund ETF Shares (ticker, VDE) with an unrealized loss of ($25,000). They could sell this holding, recognize the ($25,000) loss and then take the proceeds from that sale to purchase the Energy Select Sector SPDR Fund (ticker, XLE) to maintain their position in the energy sector. In this example we have realized the loss to reduce our net capital gain down to $5,000 while maintaining our target allocation and sector diversification.
Other considerations: Tax Loss Harvesting is typically a year end activity since by the fourth quarter there is more clarity on realized gains and losses across your taxable brokerage accounts. IRA’s or other tax deferred accounts will not benefit from Tax Loss Harvesting Short-term losses will offset short-term gains and long-term losses will offset long-term gains. Once matched, any excess losses in either category can be applied to long or short-term gains. There is a threshold for single and married filers where long-term capital gains are not taxed. For 2022 it is $41,675 for single filers and $83,350 for Married Filing Jointly, so consider your expected income for the year before proceeding with harvesting losses to offset long-term gains.
If you are interested in learning more, please feel free to contact Barry Brindise, Financial Planning Director, or David Maddux, CEO / CIO, at Brightwater Advisory.
Sources: IRS Website, Morningstar Research and “Articles”, Statista ETF Census, Charles Schwab & Co “Tax Loss Harvesting” and ETF Screener.
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