Fall is harvest time—what’s in your garden? If you find some tax losses among the melons and squash ripening there, this might be a good time to harvest them. But as always when you’re thinking about selling investments, there are several things you need to think about first. Many of them have to do with taxes.
Generally, capital losses are netted against capital gains when figuring your taxes. If you don’t have any capital gains, up to $3,000 in losses can be written off against ordinary income each year. If your loss exceeds $3,000, the excess can be carried over to future years.
In its simplest form, harvesting a tax loss means selling an underwater investment in order to write it off. If you have some dogs in your portfolio, want to put that capital to better use and can stomach taking the loss in favor of potential future gain, you might as well reap what tax benefits you can. Or, if you have already sold or want to sell a short-term investment at a gain, you might go looking for losses to offset the gains, which generally are taxed at your ordinary income rate (up to 35 percent).
What the IRS is watching for
Tax harvesting can be a much more sophisticated technique, particularly for investors with well-balanced and diversified portfolios. With the market down considerably and most people searching for the bottom, realizing losses in underwater positions and then buying them back again seems attractive. However, the IRS has special regulations—known as the “wash sale” rules—to discourage you from doing this. The IRS says a wash sale occurs when an investor sells a holding at a loss and buys a “substantially identical” investment within 30 days before or after the sale. Losses realized in wash sales can’t be written off until the replacement investment is disposed of.
Some people use tax-loss harvesting as a year-end technique, taking the loss in one tax year and buying a new investment in the next year. Others want to sell and reinvest when the market is down, then reap the benefits when the market goes back up. With careful planning, you can accomplish your goals without running afoul of the wash sale rules.
Looking for substitutes to stay in balance
One non-tax consideration might keep some investors from selling a loss position and then simply waiting out the 30 days before reinvesting. Investors who are happy with their portfolios may not want to be out of the game for that long, and it may be too long a time to leave your portfolio unbalanced. A month can be a long time in a volatile market, and we really don’t know where the bottom will be or when the market will start to go back up.
If you have enough spare cash, one way to deal with this is to buy the replacement more than 30 days before you sell your current holdings. This may leave your portfolio unbalanced for the month, and if the holding takes a dive during this period you’re now doubly exposed, so take these factors into consideration first.
Parking the sale proceeds in a similar (but not identical) investment might solve the problem. For investors who have underwater mutual fund positions they are happy with (for example, because they think the asset value will go back up, or the holding has a purpose in balancing a portfolio), exchange-traded funds might be a good substitute. Because the IRS doesn’t consider actively managed mutual funds to be substantially identical to ETFs, these investors might consider selling the active fund at a loss and replacing it with an ETF that’s based on a similar investment philosophy or index. After 30 days, they can sell the ETF and reinvest in the original asset. If the ETF fits into the portfolio just as well, some may decide to keep it and avoid the transaction fees they would incur to put things back the way they were.
Harvesting tax losses from an ETF is a bit trickier. The IRS considers selling one ETF and purchasing another to be a wash sale if the two funds are based on the same index, so looking carefully at the fund’s prospectus and/or holdings is important. If the underlying index is different the substitution may work.
Also, be aware of a similar problem with individual stocks—you can’t replace them with warrants or options on the same stock because the IRS considers those to be substantially identical investments. Futures contracts, however, are not covered by the wash sale rules.
Some tips and cautions
If you’re thinking of harvesting tax losses, here are some things to think about.
- Will the gains you’re planning to net against be short-term or long-term? If long-term, make sure your tax bill on the sale would be high enough to matter.
- What tax bracket are you in? This affects your long-term capital gains tax rate. Beginning in 2008 taxpayers in brackets lower than 25 percent have a 0 percent rate on long-term gains. If you don’t have short-term gains to net your short-term losses against, you may not get the benefit you were seeking.
- What will the transactions cost? If the expenses top the tax loss, make sure meeting your other objectives is worth the difference.
- If you’re selling a mutual fund, find out when the fund managers plan to pay out capital gains distributions. Unless you’re in a bracket where gains are taxed at 0 percent, make sure your sale goes through before the distribution. Otherwise, you’ll have to pay tax on the distribution and the value of your holding will go down just before you sell it.
- If you sell mutual fund shares at a loss less than six months after you bought them, a special rule applies that requires you to report the short-term loss as long-term. This is to keep investors from gaming the system—buying shares before a capital gain distribution and then selling them at a loss right after the distribution, once the distributed value is subtracted from the pre-distribution value.
- Don’t try to harvest tax losses when transferring assets into a business, retirement account, or family member. The IRS has rules against this as well.
For less sophisticated investors, the best tip is this: don’t try to harvest tax losses alone. If you have an investment or tax adviser, negotiating tricky situations like this is what you pay them for. If you don’t have one, this might be a good time to get some help.