The stock market has performed relatively well this year (so far, at least), despite bouts of volatility occasionally. In the last week, we’ve experienced a number of triple-digit up days and down days. It presents a good opportunity to review the rules and the value of striving for tax efficiency through harvesting gains and losses.
There are two types of gains and losses, realized and unrealized. All gains and losses are considered unrealized (and therefore, not taxable) until the asset is sold. Once sold, gains and losses become recognized for tax purposes.
Tax-loss harvesting involves selling investments for less than they cost in a non-retirement account. Even though the stock market is positive as a whole for the year, investors may be holding some stocks that are currently worth less than the original cost. By strategically selling and recognizing losses on investments, taxpayers can offset capital gains. If realized losses are in excess of capital gains, up to $3,000 per year can be claimed against regular income. In addition, any excess loss above $3,000 is carried over into future years until all of the loss has been claimed.
When harvesting taxable gains and losses, a few rules become important. The first is the “wash sale” rule. If an investment is sold at a loss, it cannot be repurchased within 30 days. If it is repurchased, the loss is disallowed. The second is the netting rule. Netting rules state that long-term capital losses must first offset long-term capital gains. The same applies to short-term gains and losses. After first netting short to short and long to long, short-term and long-term gains and losses may offset each other. Any remaining loss can be applied to future tax years and retains its original characteristics.
Let’s look at an example. If a portfolio has net long-term gains of $5,000 and net short-term losses of $9,000, then a net short-term loss of $4,000 is created. After deducting the $3,000 from income, the excess $1,000 is carried over to the following tax year as a short-term loss. In the event of a net long-term and short-term loss, the short-term is used first to deduct against income.
In any conversation about tax harvesting, it is worth mentioning that tax-gain harvesting is also a viable strategy. This strategy is mentioned infrequently, but can be a valuable tool for certain taxpayers. For taxpayers whose marginal tax bracket is 15% or below, the current capital gains tax rate is 0%. As a result, investors in this situation can harvest tax free gains due to their tax bracket. In addition, the wash sale rule does not apply when harvesting gains; it only applies to losses. Therefore, an investor could sell a stock and repurchase it seconds later to create a realized gain. A word of caution: in this scenario, a taxpayer who recognizes too much in capital gains may be pushed into the 25% bracket, thus nullifying some of the benefits of the strategy.
Tax-harvesting can be complicated and requires a well-considered strategy, but if it’s done properly it can have a significantly positive long-term effect.
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