As you’re making your year-end checklist, tax loss harvesting in your investment portfolio should be at the top of your list. With the recent stock market declines, tax loss harvesting is a high priority.
Tax loss harvesting is the process of combing through your investment portfolio for investments that have unrealized losses and then selling those investments. When an investment drops in value from your purchase price, you have an unrealized loss—known as a “paper loss”—on the investment. While on paper you’ve lost money, the loss is recognized for income tax purposes only when you sell the investment.
Once you sell the investment and recognize a loss, you can use that loss to offset taxable gains from sales of other investments in the same year, which can reduce your tax bill. If you have more losses than gains during a tax year, you can deduct up to $3,000 of net losses from your income and carry forward any extra losses above the $3,000 limit to use in future years. The leftover losses are called tax loss carryforwards.
But what if the unrealized losses in your portfolio are investments you plan to hold long term? Should you sell those investments to realize a tax loss?
Professional investors often practice tax loss harvesting by selling a security—for example, a stock or mutual fund—to realize a tax loss. They then temporarily buy back another security to continue doing the original security’s job in the investment portfolio. You can’t buy back the exact same security or else you would violate the tax “wash sale rule,” which disallows the tax loss if the same (or a substantially identical) security is bought within 30 days before or after the loss sale.
To avoid running afoul of the wash sale rule, you’ll need to buy a replacement security that is not substantially identical but performs similarly in your portfolio as the security you sold. After 30 days, you can sell the replacement security and buy back the original security. This idea applies in the context of individual stocks, mutual funds, exchange-traded funds, and other securities.
For example, let’s say you are invested in U.S. large stocks using an index mutual fund that tracks the Standard & Poor’s 500 (S&P 500) index of the 500 largest stocks in the United States. This mutual fund is at a loss, and you could sell that mutual fund and buy a different index mutual fund that tracks the Russell 1000 index, which encompasses the 1,000 largest stocks in the U.S, stock market.
The S&P 500 mutual fund and Russell 1000 mutual fund have very similar investment performance and are close substitutes. Using this pair of funds allows you to take a tax loss on the S&P 500 mutual fund while “maintaining your exposure” to U.S. large stocks. That is, your investment portfolio continues to deliver the investment performance you designed it for while allowing you to reduce your tax bill in the current year by tax loss harvesting the S&P 500 index mutual fund. Thirty-one days later, you can then sell the Russell 1000 mutual fund and buy back the S&P 500 mutual fund.
Another example with individual stocks might be selling your ExxonMobil shares, which are at a loss, and buying Chevron shares. Both are large oil companies and maintain your investment in large oil companies; however, they would not violate the wash sale rule because these are completely different companies and the securities are not substantially identical.
Of course, these are examples only and not tax advice. Whether any particular pair of securities meets the definition of “substantially identical” under the IRS definition is a factual question, and you should consult your tax advisor about your specific set of investments and tax situation.
When selecting a substitute security, be sure to select a security that you don’t mind holding for the long term. If the security you’ve swapped into rapidly appreciates in value before you swap back to the original security after 30 days, you may not want to sell it and realize short-term capital gain. You might get stuck in the replacement security.
You also don’t have to sell your entire holding of a particular security. If you bought shares of stock or exchange-traded funds at different times, you might sell only the specific shares of stock that are at a loss.
With mutual funds that are set to reinvest dividends, you will have many individual “tax lots,” which are the shares purchased with each dividend reinvestment. With dividend reinvestment, each time a mutual fund pays a cash dividend, that cash is used to purchase additional shares of the mutual fund. That quantity of purchased shares and the date they were purchased is referred to as a tax lot.
In tax loss harvesting, you might have a loss on only some of the individual tax lots and sell those specific lots without selling your entire holding. If your accounts have mutual fund dividend reinvestment turned on, any new dividend received within 30 days before or after you sell could violate the wash sale rule. Be sure to “turn off” dividend reinvestment for 31 days on the mutual funds with tax loss sales to avoid triggering the wash sale rule.
Once you tax loss harvest an investment—sell, buy a substitute, wait 31 days, and swap back to the original—you will have reduced your cost basis in the investment to the new, lower purchase price. Any appreciation from this point forward will create new gain, which will be taxable when the security is later sold. In comparison, had you not tax loss harvested, any gain from the “low” point would not be taxable on sale until the sell price exceeded the price you originally paid for the security. Tax loss harvesting changes the timing of when you realize taxable loss or gain, but not the total amount. However, the difference in timing can be valuable to you: Taking losses sooner and postponing gains until later earns you a higher after-tax investment return.
One final caution with tax loss harvesting is to be careful about buying into a new mutual fund just before capital gains distributions are paid. The value of the fund will drop by the amount of the distribution, and you’ll receive a taxable cash distribution. It’s better to wait until capital gains distributions are paid out before investing, or you’ll receive a full year’s tax bill for an investment you’ll have only just bought. While exchange-traded funds (ETFs) can pay capital gains distributions, it’s rare. This is primarily an issue with mutual fund investments.
As always, do your research and consult your advisor. Just be sure to do it sooner than later, as this option ends on December 31.
