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Tax-loss harvesting is an investment strategy used by savvy investors during market declines. A “bank” of capital losses creates a tax asset in non-retirement accounts. That asset can be used to defer, reduce, or (in some cases) eliminate taxation. At BWM Financial (BWM), we take care of harvesting losses for our clients as part of our service.

What is tax-loss harvesting, and how does it work?

Tax-loss harvesting is the process of selling investments that have dropped in value below their purchase price. This results in a realized capital loss on one’s tax returns. Capital losses are beneficial because they can be used to offset taxable gains (or income, subject to limits) and reduce one’s tax bill upon sales of profitable investments. Think of this as one way to make tax lemonade when bear markets hand you investment lemons.

Why would I want to sell an investment that has lost value?

One of the key rules of successful investing is to “buy low, sell high,” so you might be correctly wondering why anyone would want to sell an investment that has declined in value. At BWM, we simply reinvest proceeds from any investments we sell. This rebalancing allows the risk-and-return characteristics of clients’ portfolios to remain in line with their needs, objectives, and financial plans. Potential tax savings are created, and clients’ portfolios remain invested.

Can I do this with all my investments? What about my employer stock?

Many of our San Diego clients own stakes in their employer stock or other individual companies. Single stocks can be quite volatile, which may generate opportunities to sell shares at a loss. Although this sounds like a strong use case for tax-loss harvesting, repurchasing the same stock immediately after a sale will violate the IRS wash sale rule. Put simply, the IRS will disallow the loss.

At BWM, we generally invest in indexes for our clients. One benefit of owning these broad asset classes is that different investment providers offer similar highly correlated investments. This allows us to sell a security at a loss and immediately buy a different, but highly correlated, investment. Unfortunately, there’s just no way to do this for investors who own and want to immediately repurchase individual stocks.

What is the maximum capital loss deduction?

Capital losses you realize can be used to offset unlimited capital gains in a tax year. If no capital gains are created in a tax year, losses can be carried into future tax years to be used later. There’s no limit on how long you can carry them forward, so there’s little reason for investors to avoid harvesting losses if they have an opportunity to do so. It’s always possible that you may sell investments at a profit in the future. If you harvest losses now, those eventual capital gains can still be offset, even far into the future. In other words, even if you don’t need to offset gains this year, a loss can still be a valuable tax asset in a future year.

Additionally, a capital loss can be used to offset income up to $3,000 per year once gains are offset. This may be more valuable than using losses to offset gains because income is generally taxed more heavily than gains on investments held over one year.

What are the 2020 capital-gains tax rates?

For stock held in non-retirement accounts for more than one year, here are the federal capital-gains rates in 2020.

2020 Maximum Tax Rate on Long-Term Capital Gains and Most Corporate Dividends

Is tax-loss harvesting worth it?

Yes! Tax-loss harvesting can be valuable in three different ways: tax deferral, tax-rate arbitrage, or outright tax elimination.

First, harvesting losses defers capital-gains taxes. When a capital gain on the sale of an investment is offset by a loss on another investment, taxes are postponed until the replacement investment is sold (hopefully for a gain) down the road. Although taxes are eventually due, a cost in the distant future is diminished by the time value of money. Tax deferral allows for more of one’s portfolio to be invested where it can potentially grow and compound longer.

Benefits of Tax Loss Harvesting - Hypothetical Comparison

*above is a hypothetical example

Second, it can act as a form of tax arbitrage when losses are used to offset short-term gains and income taxes. When capital losses can be used to offset higher tax items ($3,000 of income or short-term capital gains, which are taxed as income), investors can benefit. When we reinvest sale proceeds into highly correlated investments, the net result is a similar portfolio with a lower cost basis in the replacement investment. If this replacement investment is owned longer than one year, eventual gains upon a sale will be taxed at long-term capital-gains rates. Long-term gains are generally taxed at a favorable rate.

In some cases, capital-loss harvesting can defer taxation until death, when non-retirement investments generally get an automatic step-up in cost basis. A step-up in basis at death effectively eliminates all unrealized gains. Taxation is completely avoided in this case.

Final thoughts

No wealth manager can control market movement, but diligent advisors can still create value during times of volatility. It’s more important than ever for advisors to consider taxation and its role in portfolio management. Tax-loss harvesting is just one tool to achieve this outcome. For information on similar strategies, or a review of how your portfolio is being managed, please reach out.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only; and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.