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Tax Loss Harvesting

Does this scenario sound familiar? You learn about a company or mutual fund that sounds like it has serious growth potential, so you add it to your taxable portfolio. There are some promising returns ¾ at first. Pretty soon though, as you perform weekly “investment checks,” you notice that your newest stock isn’t going anywhere but down. Such a situation is deflating. However, it may lift your spirits a little to know that the loss could lower your tax burden!

What Is Tax Loss Harvesting?

When you realize a capital loss has occured, it can be used to offset your capital gains. Furthermore, if your capital losses are greater than your gains, you can deduct up to $3,000 ($1,500 for those whoe are married and filed taxes separately) of the excess from your regular income. It sounds like a pretty good deal, right? It gets better: If your capital losses exceed your capital gains and the $3,000 income deduction limit, they can be “carried over” to future years! There’s no limit on the number of years that you can continue to carry forward any remaining loss.

How It Works

Here’s an example: In 2017, you buy $10,000 worth of stock of ABC Corporation and $1,000 of XYZ Holdings. ABC Corporation announces that it has been losing money for years and cannot pay its obligations. The value of your ABC shares drops to $2,000. You don’t expect any sort of recovery, so you sell the shares and realize a $7,000 loss. When you file your 2017 tax return, you can deduct $3,000 of the loss from your taxable income. Then, in 2018, you sell your XYZ shares for $5,000, realizing a $4,000 capital gain. You can “carry forward” the unused $4,000 of your 2017 “loss balance” to completely offset your return!

The Wash Sale Rule

You might be wondering, “What if I sell an investment to realize a significant loss, then buy it again? Can I still use the loss to offset my gains?” The answer is no. When you sell at a loss then repurchase the security, or any substantially identical security, within 30 days, the loss is recognized as a “wash sale.” Losses from a wash sale cannot be used to mitigate your tax liability for capital gains or lower your taxable income.

Risks

Tax loss harvesting does have potential drawbacks. Some advisers point out that by harvesting your losses you’re breaking the golden rule of investing: “buy low, sell high.” Just because an investment has dropped doesn’t always mean you should sell it. Many businesses go through ups and downs. If you sell during a dip just to lower your tax burden, you might miss out on some great returns.

In order to get around this, savvy investors will harvest a loss and switch their funds into a similar, but not substantially identical, vehicle for 31 days, at which point they trade back into the stock or fund that they were originally holding. Unfortunately, this strategy isn’t quite as simple as it sounds on paper and can introduce even more downside risk into your portfolio.

Should You Sell?

Should you harvest your losses this year? If you’re considering it, research whichever investments have slipped and ask yourself if you would be comfortable passing up any positive price fluctuations for the next month. You should hold on to companies poised to make significant announcements, such as earnings or sales numbers. However, if you don’t think the poorly performing stocks in your portfolio will ever recover, they’re prime tax loss harvesting material!

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