Monday, September 21, 2015

Does Tax Loss Harvesting work for Capital Gains and Losses?

Yes, but not for everyone.
When markets drop a popular thing to do is swap losing holdings in non-retirement accounts to generate capital losses. These maneuvers are definitely something we consider but there are several situations where the value of these trades is suspect. Frequently overlooked are that some losses aren’t useable and in the process of harvesting the losses, cost-basis is reset to a much lower amount possibly increasing future gains.
If you buy “ABC” for $50,000 and ABC drops 20 percent, you may opt to “harvest” the loss by selling ABC for $40,000 and buying a similar holding “XYZ” with that $40,000. Because XYZ and ABC are similar, your basic investment plan is intact but you have a $10,000 “realized” loss for tax purposes. This can be a smart move that saves tax dollars but not in all cases.
Tax law dictates that the loss first be used to offset capital gains. That’s nice but the tax rate on long term capital gains for taxpayers in the 15 percent marginal bracket or lower is zero so the loss may have no value to such taxpayers. Future gains will actually be greater in this case.
If the loss exceeds the year’s gains, you can use $3k against your ordinary income on your current year 1040. The value of that depends on your marginal tax bracket. You would then “carry forward” $7,000 of losses to the following year.
You also now own XYZ with a basis of $40,000. If XYZ appreciates to $50,000 and is sold, you incur a $10,000 gain. If the gain is not offset by losses or loss carryforwards, the gain is taxed at the then prevailing capital gain rate.
Real life isn’t as simple as this example. Most people have several holdings and multiple tax lots. Often, people face multiple possible tax rates through their investment time horizon. All this means multiple planning opportunities, or pitfalls. In general, the higher your current bracket relative to your anticipated future bracket, the more likely the tactic will pay off.
Tax-loss harvesting is often presented as a short-term tactical decision but really it should be considered as part of a long term strategic plan.