Tax-loss harvesting (TLH) is an important practice that can improve the after-tax returns of investors’ portfolios. Below, we discuss the benefits, best practices, and limitations of TLH.
What is it?
Tax-loss harvesting is the process of selling a security at a loss, then using the proceeds from that sale to purchase a similar security. The realized loss can now be used to offset existing or future realized gains as well as a limited amount of what is considered “ordinary income” for IRS purposes. The concept behind TLH is to generate a tax deduction without negatively impacting the returns of your portfolio; in a way, TLH can be thought of as a “silver lining” when your investments inevitably experience volatility and bear markets. Because the IRS allows you to carry losses forward, you can “harvest” losses at any time to be used against future taxable gains. TLH only makes sense in taxable accounts, as there is no benefit to this practice within an IRA or any other tax-deferred or tax-exempt account.
The wash sale rule
Above, we mention that in order to execute TLH, you must use the proceeds from your sale to purchase a “similar security.” The IRS prohibits you from selling an investment at a loss and buying a “substantially identical” security in its place within 30 days of the sale. This is known as the wash sale rule, and it exists because the IRS has no interest in giving you a free tax deduction every time the market goes down. Here are some scenarios to consider:
- 1: You sell Home Depot stock at a $1,000 loss, and buy Home Depot back 2 days later.
- 2: You sell Home Depot stock at a $1,000 loss, and buy Home Depot back 31 days later.
- 3: You sell Home Depot stock at a $1,000 loss, and buy Lowe’s stock immediately. Home Depot and Lowe’s perform very similarly over the next month, and 31 days later, you sell Lowe’s and buy back Home Depot.
Which of these violate the wash sale rule?
Example 1 is a violation of the wash sale rule because you have purchased the identical security back within 30 days. As a result, any loss realized is disregarded and not allowable for the purposes of offsetting taxable gains. It is important to note that this applies regardless of the accounts involved in the transaction (e.g. even if you sold Home Depot in your taxable account and bought it back in an IRA, the rule still applies).
Example 2 is not a violation and your loss can be used to offset taxable gains. This is because you waited 31 days to buy back the security. However, if Home Depot had bounced back (which can often happen quickly after a steep decline) during these 31 days, you would have missed out on these returns and purchased back the security at a much higher price.
Example 3 is also not a violation of the wash sale rule and is a classic example of TLH. In this case, Lowe’s and Home Depot are both in the business of home improvement, but they are not “substantially identical.”
The benefit of tax-loss harvesting
Before we discuss the risks of TLH, we should explore its benefit a bit further. We find that people often overestimate the benefit of tax-loss harvesting by only factoring in the value of the current tax deduction, without considering its future implications.
Let’s return to Example 3 from above, where the investor has harvested $1,000 of losses. Suppose this investor has an effective tax rate of roughly 40% and uses these losses to offset $1,000 of short-term capital gains. At quick glance, the value of the TLH is $400 of savings on this year’s tax bill, and the fact that this $400 remains in your portfolio to earn returns. However, the analysis cannot stop there – Home Depot was sold at a lower price than it was originally purchased for (hence the loss). Therefore, assuming (not a given) you purchase it back at a similar price compared to the one you sold it at, your cost basis has been reduced. As a result, if you sell Home Depot again after a material increase in value, then your realized gain at that point in time will be significantly higher than it would have been had you never engaged in TLH. Ultimately, the true benefit in this case is from any after-tax earnings on the $400 of tax savings. The bottom line: TLH is more of a tax-deferral strategy than a tax-reducing one.
Finally, there are two general scenarios where the value of TLH greatly increases, and it becomes both a tax-deferral and tax-reduction strategy:
- If you hold your portfolio until death and your beneficiaries receive a step-up in basis. Going back to our example, if you hold Home Depot until death, and allow your tax-deferral to “work” for you over many decades, then you receive a step-up in basis on the stock and avoid the realization of any unrealized gains built in to your position.
- If you use the harvested securities for charitable donations. This is similar logic to the above scenario. Suppose in Example 3, you eventually use your Home Depot stock to make a charitable donation. In this case, you reap the benefits of your tax loss and then also avoid the increased taxes associated with a future sale at a higher price via the charitable deduction. See our post on charitable giving for more information on donating individual securities.
So is TLH a “no-brainer”?
Nope, we still don’t see it as LeBron stealing an opponent’s pass and going the other way (see: slam dunk). TLH carries various risks:
- Divergence in performance between the primary security and the substitute security (“tracking error risk”). This can happen two ways – back to Example 3.
- If during the 31 days of holding Lowe’s stock, it drops 10% while Home Depot rises 10%, you are considerably worse off.
- If both Lowe’s and Home Depot see very strong performance during the 31 days, then you will incur material short-term gains should you execute the second leg of your TLH transaction and swap back into Home Depot. Had your original position in Home Depot been long-term, then it is possible that you have created a larger tax bill as a result of the TLH.
The way to mitigate tracking error risk is by selecting substitute securities that have a high probability of tracking closely with your primary security over both short and long-term time periods.
- Tax bracket risk. This refers to the possibility that you harvest losses but defer gains into the future at a much higher tax bracket. Depending on the jump in tax bracket, it is possible for the additional tax in the future to more than offset any tax-deferral benefits achieved from TLH. Being in a high tax bracket increases the value of the tax deferral, and it reduces the probability that the capital gains tax bracket will be significantly higher at the time of account liquidation (assuming most people move to a lower bracket prior to death, without making predictions on government policy).
- Holding period reset risk. For investors in high income tax brackets, capital gains taxes are significantly higher on short-term gains (less than a year) than on long-term gains. Suppose in Example 3 you were holding Home Depot for 330 days at the time of sale and captured a short-term loss. When you purchase it back, the holding period is reset to 0. If Home Depot increases dramatically over the next 60 days and you sell it, you will realize a large short-term gain, and potentially be worse off than if you never engaged in TLH and had realized a [smaller] long-term gain at a lower tax rate.
- Fees incurred while TLH: In order to sell a security and buy back another one, there are two transactions (each with a fee) that have to occur. There is also the potential that it is in the portfolio’s best interest to buy back the original sale after the 30-day wash-sale period has ended, resulting in four total transactions – each of which may incur a fee. It is important to make sure that the fees associated with TLH do not outweigh the economic benefit.
- Length of investing period: Given that TLH is primarily a tax-deferral strategy, the value of TLH increases over time, allowing the earnings on your deferred taxes to compound each year (which is especially true if the portfolio is held until death). There is no discrete length of time required to realize the benefits of TLH, and it is path-dependent, meaning that if you opened an account in 2007 (pre-global financial crisis), you would realize benefits far more quickly than if you opened one in 2009 as markets were recovering. What we do know is that TLH should not be done on a short-term horizon.
How we execute tax-loss harvesting
We consider all of the above risks when determining if we should harvest losses in our clients’ portfolios. Overall, while we can never eliminate the risks associated with TLH, we believe that we can reap the benefits of TLH while minimizing such risks on behalf of our clients. This is because we:
- invest for the long-term,
- have negotiated low transaction costs with our custodians,
- typically invest in broad market funds which allows us to use other similar (but not identical) mutual funds and ETFs in order to mitigate tracking error risk, and
- construct diversified portfolios, leading to a higher likelihood that there are “losers” available to harvest (see our recent post The Power of Diversification for more on this).
Finally, it is our duty as the investment manager to constantly monitor the portfolios of our clients. We watch for certain thresholds to be surpassed in order to capitalize on both tax-loss harvesting and rebalancing opportunities.
- Tax-loss harvesting is a tax-deferral strategy that provides long-term investors with the opportunity for greater after-tax returns.
- Tracking error, fees, time horizon, tax situation, and security holding period are all factors that need to be considered when approaching tax-loss harvesting.
- Opportunities for TLH aren’t always available, but they do occur naturally when one owns a diversified portfolio in an ever-moving market.