When life gives you lemons, make lemonade.
We’ve been using that phrase a lot lately. Then again, we’ve been given a lot of lemons lately. Many of our clients, friends, and family have encountered some really hard challenges. Things like temporary business closures, reduction in business revenue, working in a high-risk essential business, unemployment, and investment losses. Not to mention the potential to actually contract COVID-19 or have a family member contract COVID-19. For many of those challenges, the best we can do is control the damage.
However, for some of the challenges we experience, there can be silver linings. From things as little as a disruption to our daily routines to things as big as major market declines, we at Flagstone have been searching for ways to make the best of what we’ve been given. A couple of weeks ago, you might have read about our work-from-home life. We’ve all tried to identify and enjoy the good things about our new lives. My most recent “batch of lemonade” was purchasing a new vehicle. Manufacturers are offering some really appealing incentives because no one is buying vehicles right now! Some of us have refinanced mortgages to take advantage of low rates. And others are enjoying a renewed focus on what they really value in their lives.
We’ve been trying to make lemonade for our clients, too. One specific lemonade opportunity that comes up during bear markets is something called tax loss harvesting.
But first, a word of warning.
Before I explain how tax loss harvesting works, I want to start with a necessary disclaimer. Tax loss harvesting is very complex and can cause unintended consequences. If you’re unsure of how it works, the specific rules, how it affects your taxes, or really any aspect of tax loss harvesting, you shouldn’t do it on your own. There can be some positive long-term effects, but it’s also easy to screw up. Consult your tax advisor, your financial advisor, your spouse, your barber, and your dog walker before executing any tax loss harvesting strategy. Obviously, I’m kidding about the latter people, but in all honesty, this is not something you should take lightly. And you should enlist the help of professionals.
Executing the tax loss harvesting game plan.
Now, let’s move on to the education. If done the right way, tax loss harvesting is a means to intentionally realize capital losses in a nonretirement account while staying invested in the markets. You can use those losses in the current tax year to offset capital gains — or even ordinary income to an extent. If you have more losses than you are allowed to use in the current year, you can carry those losses forward into future tax years. The bottom line is that it might lower your tax bill.
So how does it work? Let’s say you buy Mutual Fund A on February 1 for $800. On March 15, Mutual Fund A is only worth $600. You have a $200 short-term capital loss in that scenario. But it’s unrealized. You haven’t sold it yet, so you haven’t “realized” the effects of the loss. So, let’s say you sell it. At that moment, the unrealized capital loss becomes realized. And you can claim that capital loss on your taxes for that tax year.
Tax Man: 0
Now if you were to sell Mutual Fund A to claim the loss and you kept the proceeds from the sale in cash, you’d be “out of the market.” If the market rebounds, you don’t get to participate in that rebound because you’re holding cash. As a prudent investor, it’s usually best to maintain your current investment strategy when markets are being volatile instead of trying to time the markets by moving to cash or anything else that’s dramatically different than what you previously owned. So, after you sell the investment to realize the loss, you should typically buy another investment that was somewhat similar to what you sold. In our example, let’s say Mutual Fund B is similar to Mutual Fund A. So you sell Mutual Fund A for $600 to realize the loss, and buy $600 worth of Mutual Fund B.
Here’s where tax loss harvesting gets complicated.
The IRS doesn’t allow you to buy something that’s a substantially equal investment and still get the tax benefits of claiming the loss. For example, you can’t sell an index fund that’s based on the S&P 500, then turn around and buy a different index fund that is based on the S&P 500. Those funds probably have the exact same 500 stocks. If you did do that, it would be something called a “wash sale,” and the IRS wouldn’t allow you to claim the loss. In order to claim the loss, you have to buy something else that is different enough to avoid a wash sale. But you want it to be similar enough to the original investment because, as a long-term investor, you don’t want to dramatically change the makeup of your investment portfolio.
Once 30 days pass, the IRS allows you to “unwind” the trades. In our example, this would mean you sell Mutual Fund B on April 16. Wait until 30 days have passed. And then purchase Mutual Fund A. Your portfolio would look pretty much like it did had you not done anything, but you got to claim the tax loss.
But there may be reasons you don’t want to unwind the trades. Remember, you purchased Mutual Fund B for $600. What if 30 days pass, and Mutual Fund B has grown to be worth $900? Well, if you unwind your trades by selling Mutual Fund B and purchasing Mutual Fund A, you’d be realizing $300 of short-term capital gains. Earlier in the year, you had realized a $200 short-term loss. The $200 of losses will offset your $300 of gains. But you’ll still be left with a net of $100 in short term gains.
Tax Man: 2
Our recommendation: Enlist the help of professionals.
This article is just an introduction to the idea of tax loss harvesting. The reality is that there are many other rules of tax loss harvesting that make it even more complicated. Some of those operational and portfolio management complexities cause tax loss harvesting to not be worth it. If done improperly, you might end up owning an investment in the long-term that you didn’t want to own. Or that isn’t aligned with your objectives. You might incur a bunch of costs that outweigh the time it takes to execute the strategy or the tax benefits of the strategy. On top of the complexity of the investment side of tax loss harvesting, complexities of a person’s tax situation might make the tax benefits worthless — even if the tax loss harvesting strategy was executed with perfection.
However, if done the right way, tax loss harvesting can be a way to lower your tax bill in the current year (and maybe your long-term tax bill) without making major changes to your portfolio. That way you don’t risk missing out on a market rebound. Just be sure you know what you’re doing and that you have help from qualified professionals before you try to make a batch of tax lemonade with bear market lemons.