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Tax-Loss Harvesting: The Tax Loophole You Are Missing Out On

Often we hear about the tax loopholes that millionaires and billionaires are taking advantage of while the average Joe is left holding the bag. This is generally a mischaracterization, as these millionaires and billionaires are subjected to the same tax code as the rest of us. They simply take advantage of the tax code either by knowing and understanding it, or hiring advisors who do. Today’s blog deals with one of those tax advantages that you may not have known about: tax-loss harvesting.

What the Heck is Tax-Loss Harvesting?

One of the only benefits of your investments losing money is the potential to utilize those losses for tax advantages. This is the basic theory of tax-loss harvesting; use losses in your investment portfolio to offset gains in your investment portfolio. Before we go too deep, let’s look at a basic example of how this works.

Let’s say you purchased 100 shares of XYZ stock for $10,000. Over time, the value of the stock decreases to $6,000, resulting in a loss of $4,000. You then decide to sell the stock and realize the loss. This loss can then be used to offset capital gains in other investments. For example, if you sold another stock for a gain of $4,000, then you could use the $4,000 loss from the XYZ stock to offset that gain, resulting in no taxable gain.

One important note on tax-loss harvesting is that it only works with capital assets…those in which you have a capital gain, or in this case, a capital loss. In other words, this does not work with your retirement plans. While you may (and many certainly do after the down year of the stock market) have losses in your tax-deferred retirement accounts, these losses are not eligible to be used in tax-loss harvesting. However, if you have any non-qualified investments that have lost value these are prime candidates to be used in tax-loss harvesting.

The $3,000 “Loophole”

While tax-loss harvesting only deals with losses on capital assets, there is a loophole in the tax-code that allows the first $3,000 of loss to be applied against your income taxes. Income tax rates are always higher than capital gains tax rates, so this benefit would be used first before offsetting any capital gains. The example above is illustrated for benefit of simplicity, however in practice (assuming you have income), you would actually deduct the first $3,000 from your income and the remaining $1,000 would be used to offset your capital gain.

But What if I Don’t Have any Capital Gains to Offset?

One of the great benefits of this tax provision is its ability to carry forward indefinitely. In other words, using the same example above of having a $4,000 loss, the first $3,000 would still be used to offset your income taxes, but if you had no capital gain to off-set then you would carry that loss forward to be used against capital gains in future years. While there can be compelling reasons to hang on to assets that have shown a loss, between the income offset and the indefinite carryover, harvesting that capital loss is a benefit that should be strongly considered whenever the opportunity presents itself.

Beware of the Wash Sale Rule

So if I sell my position at a loss, can I immediately buy back in to the same position?

The wash sale rule deals with this exact scenario. In order to gain the tax benefit, you cannot sell a stock and immediately buy back in. You must wait at least 30 days.

Instead of waiting 30 days, can I just invest into something very similar?

Yes, but…

The IRS says that you cannot re-invest into something that is “substantially identical” within 30 days (on either side) of the sale. In dealing with stocks, identifying substantially identical is pretty easy…just don’t buy the same company. For example, if you sell a position in Apple, and pick up a position in Microsoft, these are not considered substantially identical. However, when dealing with mutual funds it is not quite as clear. Everyone loves dealing with ambiguity in the tax code right 😐. While the IRS in their graciousness gives us virtually no guidance on what is considered “substantially identical”. When I work with clients, I deploy the industry’s general rule of thumb; if two mutual funds’ holdings contain less than a 70% overlap, then they are not considered to be substantially identical.

Don’t Miss Your “Loophole”

With the losses sustained in the capital markets over the last year, it is worth your time to do a deep dive into your holdings to see if you have any assets that are eligible to take advantage of this tax provision. While I never recommend making investment decisions solely off of tax benefits, if done strategically, and within the context of your overall financial plan, utilizing tax-loss harvesting has the potential to save you tens of thousands of dollars over your lifetime.

This post is for educational and entertainment purposes only. Nothing should be construed as investment, tax, or legal advice.

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