By Shelburne Fiduciary Partners | April 13, 2021
It's a fact of investing that markets sometimes go down, and occasionally by a lot. It's also generally true that not all investments will perform well at the same time. For example, at any given time, small cap stocks may increase in value at the same time large cap socks decrease, or vice versa.
As we have discussed elsewhere, long-term trends and return probabilities tend to favor those who own a diversified portfolio and who avoid market timing. Patient investors who have an appropriate level of risk in their portfolios should be unfazed by the type of market fluctuations described above.
In fact, there can be times where an investor with a long-term horizon actually benefits from them. We often point out that market declines provide the opportunity to purchase additional shares at a lower price. This is great for regular savers who employ a dollar cost averaging strategy.
For investors with a taxable brokerage account, temporary market declines provide another potential benefit: the opportunity for tax loss harvesting. In some cases, this strategy can help to materially reduce an investor’s near-term tax bill.
Tax loss harvesting refers to selling an investment strictly to lock in a tax loss. The loss can then be used to reduce the investor’s current or future taxable income.
For example, an investment purchased two years ago for $10,000 that is now worth $9,000 can be sold to realize a $1,000 long-term capital loss. That loss can be used in the current tax year to offset gains realized on other investments or to reduce the investor’s ordinary taxable income by up to $3,000. Unused losses can be carried forward for use in future tax years.
An important caveat is that the IRS disallows the tax loss if the investor purchases the same or a substantially identical security within 30 days before or 30 days after the sale that generated the loss. This “wash sale” rule is designed to prevent abuse of the tax code by ensuring that a tax benefit cannot be obtained without also making a meaningful change to the investment holdings. Otherwise, it would be possible for the investor to sell shares to realize a tax loss and then immediately repurchase the exact same security, thereby making no real change to the portfolio’s risk profile.
When employing a tax loss harvesting strategy, most investors want to reinvest any sales proceeds in order to maintain their desired exposure to the market. It is important to ensure that the reinvestment happens without triggering a wash sale.
For investors who utilize index funds (as we do at One Day In July), one option is to replace the fund being sold with a fund benchmarked against a different, but reasonably similar, index. For example, a fund benchmarked against the Russell 1000 index could be sold to generate a tax loss and replaced by a fund benchmarked against the S&P 500. Both indexes track large cap U.S. stocks, but have somewhat different compositions. If the investor wanted to regain the exposure to the Russell 1000 fund, it would be possible to do that after waiting more than 30 days.
When the market drops materially (e.g., the first quarter of 2020 or the first half of 2022), there may be many positions in a portfolio that show an unrealized loss. In those situations, a tax loss harvesting strategy may allow an investor to realize a substantial amount of losses that can act as a “loss bank” for use in the future. Because the sales proceeds are quickly reinvested in relatively similar securities, the investor does not sacrifice the upside when the market recovers.
The loss bank can be carried forward to future years to offset gains once the market has recovered. It can also be used to offset future gains arising from other assets the taxpayer owns. For example, the sale of a rental property or a business could generate a substantial tax bill that an existing loss bank would help to mitigate.
A tax loss harvesting strategy is probably most useful to high-net-worth investors who are more likely to incur a large future capital gain that can be reduced through this strategy. At One Day In July, we will consider a tax loss harvesting strategy when it fits well with the investor’s overall investment and wealth management goals.
The above article is based upon tax rules in place as of 2022. These rules may change in the future. The above should not be construed as tax advice, and investors should consult their tax professional.
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