Harvest Those Losses

You may have noticed that the stock and bond markets have both significantly declined in value in 2022. No one likes to see their investments go down but there may be one silver lining — harvesting capital losses in your taxable portfolio.

What is tax loss harvesting?

When you own an investment that is worth less than you originally paid for it, you have an unrealized loss. If you chose to sell it, you would convert the unrealized loss into realized one.

Generally, capital gains taxes are incurred only upon the sale of an investment and if you realize a loss instead of a gain, you can apply the full amount of that loss against any realized gains you have elsewhere. This is tax loss harvesting — when you have unrealized losses, you sell and lock in the loss as a taxable event to reduce your taxes for this year or in the future.

Depending on your situation, this could amount to a significant tax savings.

With few exceptions, it is usually a good tax strategy to realize losses and defer gains. The tax loss is a sure benefit now and the gains are delayed to some future time when who knows what the circumstances may be, including not realizing any gains ever.

When you die with unrealized gains, typically the cost basis of your investment is “stepped up” to the market value at the time of your death. In English, this means that any unrealized gain is wiped away and your beneficiaries would likely not owe any capital gains tax on the sale of the assets at the time of your death.

What if you don’t have capital gains that can be offset with capital losses?

When you realize a capital loss (by selling the asset), the IRS requires you to first use that loss to offset any capital gains. If you don’t have any capital gains for this year, the IRS allows you to apply up to $3,000 per year of capital losses to offset ordinary income so, minimally, you’ll get that savings.

For any remaining unused losses, you can do a tax loss carryforward which, in a pleasant surprise for IRS jargon, means just what it sounds like. You carry forward into future tax years the remaining capital losses and apply them against future capital gains and/or $3,000 per year of ordinary income until the tax loss is depleted. There’s no time limit on using the tax loss carryforward.

If you’re wondering, you cannot carry them backward and any unused carryforward balance expires when you do.

Be wary of a wash sale.

You may be thinking, what do I do with the money after I sell the investment? Can I simply re-purchase what I just sold?

The IRS has a “wash sale” rule. Basically, if you buy a “substantially identical” investment within a 30 day window before or after your sale, the capital loss will be negated. I will not weigh in on exactly what substantially identical means in this context but you get the idea. Fidelity has a good explanation of it here.

You can rebuy exactly what you had after 31 days or you can buy something else right away that is not substantially identical. In our world of thousands of ETFs and mutual fund choices, it shouldn’t be too hard to find another investment that is similar to what you held (if you want that) but not substantially identical.

What about retirement accounts?

IRAs and 401Ks are not relevant for this strategy. You typically only pay tax when you take distributions and these are taxed at ordinary income tax rates. You don’t pay taxes on capital gains and you derive no benefit from any capital losses.

Any reason not to do this?

I don’t know of any good reasons not to do so. Many investors have a psychological resistance to accepting losses (behavioral economists call this the endowment effect) but you need to understand that the loss has already occurred and you’re just tax-optimizing at this point.

At least once per year, review your taxable portfolio and unload the losers. Now might be a good time to take a look. You’ll make some lemonade out of lemons.