John Gorlow
| Nov 06, 2015
This appealing strategy has pitfalls, too
Who doesn’t want to reduce their tax bill? At the end of the year, one popular tactic is tax loss harvesting, a strategy of selling stocks, mutual funds, exchange-traded funds and other investments that are worth less than what one paid for them. The idea is to use losses to offset realized capital gains on other investments. On the surface, tax loss harvesting seems attractive, but is it a good fit for the long-term investor? It depends.
Tax loss harvesting typically works in one of two ways. The first method is to sell a security that has diminished in value and immediately replace it with a similar security, hold it for 30 days, then sell it and buy back the original security. The second method is to harvest the loss and wait on the sidelines for 31 days before re-establishing the original position. Either way, the objective is to avoid a violation of the IRS “wash” sale rule, which disallows tax savings on a loss if the position is sold and then re-purchased within 30 days.
Here’s an example. Let’s say an investor has a position in “XYZ” with an original purchase price of $750,000, which has now declined in value to $500,000. To harvest that loss, XYZ is sold, resulting in a $250,000 portfolio loss. To steer clear of the IRS’s wash sale rules, a similar position in “ABC” is purchased and held in the portfolio for 30 days, then sold. XYZ is then repurchased. Assuming there is no change in the price of either XYZ or ABC over the 30-day period, and XYZ was in the portfolio long enough for any capital gains tax to be at the long-term rate, the investor now has a cost basis in XYZ of $500,000 and a harvested loss of $250,000.
Assume XYZ appreciates 50% and is again worth $750,000, and at some future point the investor sells it in its entirety. The investor now has an additional $250,000 in capital gains on XYZ. This is because the act of tax loss harvesting reset the cost basis to $500,000. In other words, the tax loss harvest transaction ends up canceling itself out since the tax losses have been offset by additional capital gains when the asset is eventually sold.
While tax loss harvesting delays capital gains taxes, escaping them altogether is difficult. There are a few ways to do that. First, don’t reinvest harvested proceeds into stocks (not very practical for most people). Another alternative is to reinvest, then keep carrying the reinvested proceeds forward until the time of death, at which time the IRS’s step-up-in-basis rule re-sets the basis and no capital gains are owed.
For the large majority of investors, taxes will eventually have to be paid on gains. Most people are likely to need the money at some point, so staying invested until death is not realistic. And if future capital gain tax rates rise, as many experts believe they will, the tax liability could be higher than the benefit realized by harvesting losses today.
If there are no capital gains to offset in a given year, absent unusual circumstances, there is hardly any tax advantage to stockpiling capital losses since these losses may only be applied against a maximum of $3000 of ordinary income.
Under what circumstances could stockpiling capital losses make sense? Take for example a situation in which all three of the following exist in the same year: 1) a substantial capital gain is expected to be recognized, 2) the current losses are at risk of being eroded due to expected price increases, and 3) proceeds from the loss harvesting are not used to re-purchase securities that are expected to be sold at gains in the same year.
Loss harvesting also involves the risk of undesirable consequences. First, the value of the strategy may be eroded by transaction fees and by “tracking error” if the substitute position held to avoid the wash sale rule does not perform in line with the original investment. Second, if the proceeds from the loss harvest are kept out of the market for 31 days before being re-invested into the identical position, the investor risks being whip-sawed by upward movements in market prices during the time lapse, causing underperformance.
There’s another risk too, in being seduced by the uptick in marketing of tax loss harvesting. What used to be a year-end practice is now evolving into a year-round strategy touted by firms that aggressively look for and harvest portfolio losses right away, with the aim of circumventing capital gains in other parts of the portfolio while enhancing overall performance. Keep in mind that the benefits of tax loss harvesting are difficult to quantify, and the value of the strategy is likely to be overestimated by high-fee advisors seeking a share of your wallet. Even if there is some benefit to be realized from tax loss harvesting, shouldn’t it go to you instead? And consider the downside of aggressively applying this strategy: it’s possible to end up with a portfolio with only capital gains in it.
Bottom line, apply this strategy judiciously. Tax loss harvesting may generate current tax savings, but could also trigger a potential future gain that offsets most or all of the loss harvesting benefit.
Remember that passive and index portfolios have inherently low annual capital gains distributions because their turnover is low. The funds favored by Cardiff Park Advisors offer tax-managed and tax-advantaged portfolios where losses and gains are offset internally within the strategies. We can and do work with clients on request to harvest losses, but recommend letting fund managers navigate taxes within their funds rather than doing it yourself through tax loss harvesting.