January 03, 2023
What Is Tax Loss Harvesting? An Overview of the Potential Benefits and Risks
A tax loss harvesting strategy can yield a significant tax benefit, particularly amid stock market volatility. Tax loss harvesting is the strategy of selling stocks, mutual funds, exchange-traded funds (ETFs) or other investments in a loss position, then capturing those losses to use to offset realized gains from other investments. Here, we provide an overview of the potential benefits and risks of tax loss harvesting.
The Internal Revenue Code stipulates three important aspects of capital losses for individuals:
- There is no limit on the amounts of gains that can be offset in a year, nor are there any phase-out or other qualifiers to usage.
- Excess losses may be used to offset up to $3,000 of other types of income, such as wages, interest and dividends.
- Losses that cannot be used in the year realized can be carried forward to the following years indefinitely.
The combination of the first and third points provides the major impact of tax loss harvesting: Losses can be “booked” and fully used in the future, whenever and to whatever extent there are gains.
Under current tax rules, an individual can offset losses for a given type of holding against the first gains of the same type (e.g., long-term gains against long-term losses). If there are not enough long-term gains to offset all long-term losses, the balance of long-term losses can go toward offsetting short-term gains, and vice versa. All remaining losses are carried forward.
There are several risks to tax loss harvesting. Sometimes loss harvesting is part of a portfolio rebalancing; other times it is done simply for the tax benefit. In the latter case, as with any action taken solely for tax purposes, it is important to carefully analyze risks before proceeding. In addition to the need to navigate the wash sale rule, as we discuss later, there are additional considerations, including:
- The replacement or acquired asset spikes in value, forcing the recognition of short-term gain if sold to repurchase the original stock or security. This is troublesome because of the current higher marginal rate on short-term versus long-term gain.
- The sold stock or security spikes in value during the time it is not owned. Aside from “missing out” on the growth, it places one in the unenviable scenario of having sold low and repurchasing high — or waiting and hoping for a retreat in value before repurchasing.
- The sale and replacement may negatively impact diversification of the overall portfolio, potentially putting the benefits of diversification at risk. This is particularly true when the proceeds are not reinvested but held as cash (awaiting the 30 days), or when reinvested in a manner that causes an overweighting to the investment policy.
How the Wash Sale Rule Applies to Tax Loss Harvesting
The primary constraint to capturing a qualified capital loss is the so-called “wash sale rule.” This rule is intended to dampen efforts to manipulate taxes “artificially” through the prompt sale and repurchase of the same investment. In other words, if you buy the same or “substantially identical” stock or security within 30 days, the loss will be ignored for tax purposes.
A wash sale occurs if within the time period you:
- Buy substantially identical stock or securities.
- Acquire substantially identical stock or securities in a fully taxable trade.
- Acquire a contract or option to buy substantially identical stock or securities.
- Acquire substantially identical stock in one’s IRA or Roth IRA.
The wash sale rule has three potential traps:
- Timing: The purchase of the stock or security cannot be made within 30 days before or 30 days after the loss position is sold. A purchase made during this period will negate the loss recognition.
- Repurchase: The rule is triggered if the same or substantially identical investment is purchased during that closed window. To determine whether stocks or securities are substantially identical, the IRS dictates that you must consider all the facts and circumstances relevant to their situation. Stocks or securities of one corporation typically are not considered substantially identical to those of another corporation. Further, bonds and preferred stock of one corporation are generally considered separate from those of another corporation. The analysis is usually straightforward when the sold item is the direct ownership of a stock or security. Taxpayers who want continued exposure to the market segment of the sold stock or security could consider purchasing a relevant mutual fund or ETF. But the inverse can be tricky. That is, when what is sold is a fund or ETF, it may not be possible to find a qualified replacement fund or ETF with the same theme or in the same sector.
- A wide net: The restriction on purchasing the same or substantially similar stock or security is not limited to the account in which the stock or security was sold — it applies across all of the taxpayer’s (and spouse’s) accounts.
The Internal Revenue Code provides ordering rules for when the amounts sold and acquired are different. In these situations, you must match lots under a defined set of rules. If the value of the acquired stock or securities is less than what was sold, the acquired shares will be matched based on the date of their acquisition, beginning with the earliest. If the acquired amount is equal to or more than the amount sold, the matching of the acquired stock or securities also will be based on the date of acquisition, beginning with the earliest.
What is the penalty for violating the wash sale rule?
There is no penalty per se if the wash sale rule is violated, but the loss from the sale is not recognized. A realized gain or loss is when an asset is sold for more or less than its cost basis; a recognized gain or loss is the amount taxable. Thus, when the wash sale rule is triggered, although the loss is realized, it may not be recognized for tax purposes, meaning you do not get the benefit on your tax return.
For example, a stock with $2,000 basis is sold for $1,000 (a $1,000 realized loss). On the same day, the same number of shares of the same stock is purchased for $1,000; thus, the loss cannot be recognized. The basis in the acquired stock will be adjusted to $2,000 (purchase price plus unrecognized loss). There is an exception to this rule, but it is of no consequence to a taxpayer. That is, if the stock is repurchased in an IRA or Roth IRA, there is no basis adjustment for the unrecognized loss, which has no impact, as a subsequent distribution will be either taxed as ordinary income or not taxed at all. Taxpayers who knowingly trigger the wash sale rule must complete a requisite reporting requirement.
The U.S. Treasury characterizes cryptocurrencies as property. As such, realized losses may fall under the same tax-loss harvesting benefits identified above. However, most cryptocurrencies are neither a stock nor a security. Thus, the wash sale rule may not apply to losses on the sale of directly owned cryptocurrency. Cryptocurrency loss harvesting has caught the attention of Congress, the IRS, and the SEC, all of whom have made inchoate efforts to eliminate this treatment. There is an expectation of future efforts to subject them to §1091. Regardless, while direct ownership of cryptocurrencies may not (yet) fall under the wash sale rule, indirect ownership such as through an ETF may.
Ways to avoid the wash sale rule
There are some simple techniques that can be used to realize losses and yet maintain a position in the market until the wash sale period has expired.
- Invest in a fund that reflects the sold position’s market segment. Although this technique does not entirely replicate the initial position, it provides some exposure. For example, if XYZ tech stock is sold on Day 1, promptly purchase a tech ETF or tech mutual fund. When the 30-day period has passed, sell the fund or ETF and then repurchase the XYZ stock, if then desired.
- If the plan is to sell an entire position at a loss in order to offset gains, but you still want to own the stock, buy additional shares and wait out the rule period of 30 days. Thereafter, sell your original position.
- Buy a call option on the stock that is to be sold. Once the wash sale rule closed window ends, sell the shares and realize a loss that can be recognized. The call option has kept exposure to the market.
- Consider selling some, but not all, of the shares for a loss and leave it at that. Since there won’t be a purchase within the rule’s window, there will be a recognizable loss and still a maintained position in the stock. For instance, if 200 shares are owned, sell only 100. As soon as the 30 days is up, buy 100 more shares to replenish the position.
Capital losses reflect the reality of a drop in value. While no one wants to lose value, harvesting losses for tax purposes can provide a financial silver lining — and one that does not expire. To capture recognizable losses, be opportunistic, follow the rules, and consult your tax advisor.
For more information on how to capture downturns in market value in order to save taxes currently or in the future via tax loss harvesting, please contact your tax advisor or Glenmede Relationship Manager.
This material provides information of possible interest to Glenmede Trust Company clients and friends and is not intended as investment, tax or legal advice. Any opinions, recommendations, expectations and/or projections expressed herein may change after the date of publication. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Clients are encouraged to discuss any matter discussed herein with their tax advisor, attorney or Glenmede Relationship Manager.