At Goodman Financial, we believe that managing a portfolio is about more than selecting good investments. It is also about being mindful of the tax impact of those investments throughout the year, not only when you file your return. One of the tools we consider in that effort is tax-loss harvesting. It is a strategy that sounds simple on the surface, but the details are where it can either add value or create unintended consequences. Below is a high-level look at how it works, when it tends to help, and the caveats that make thoughtful execution so important.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the practice of intentionally selling an investment that has declined in value in order to realize a capital loss. That realized loss can then be used to offset realized capital gains elsewhere in your portfolio. If your losses exceed your gains for the year, you can generally apply up to $3,000 of the excess loss against ordinary income ($1,500 if married filing separately), with any remaining loss carried forward to future years indefinitely. Losses and loss carryforwards are first matched against gains of the same character (short-term losses against short-term gains, long-term against long-term) before being netted against the other category.
Once a loss has been harvested, you generally have two choices for the proceeds of the sale, and each carries its own tradeoffs. One option is to leave the proceeds in cash through the wash sale period the rules require (discussed below). This fully avoids any risk of disallowing the loss, but it leaves you temporarily out of the market and exposed to missing a rebound if prices recover. The other option is to reinvest in a substantially similar (though not substantially identical) investment, which keeps your market exposure largely intact, but introduces some tracking differences from your original holding and requires care to stay on the right side of the wash sale rule. Which approach makes sense depends on the situation, and neither is free of drawbacks.
Why It Can Be Valuable, and When It Helps
The primary benefit of tax-loss harvesting is one of timing. By realizing a loss now, you may be able to defer tax you would otherwise owe, leaving more of your money invested in the meantime. For taxpayers in higher brackets with sizable taxable (non-retirement) accounts, that deferral can be meaningful over time.
The strategy tends to be most useful in a few situations: during volatile or declining markets, when losses are more readily available; in years when you expect to recognize sizable gains, for example from rebalancing, diversifying a concentrated position, a fund’s year-end capital gain distributions, or the sale of a business or property; and as a complement to disciplined portfolio rebalancing. It’s particularly helpful if you are in a higher capital gains bracket now when harvesting the loss versus a low capital gains bracket in the future. It is worth noting that the strategy applies only to taxable accounts. Losses inside IRAs, 401(k)s, and other tax-deferred accounts cannot be harvested.
The Caveats Worth Understanding
This is where careful execution matters, and where a few well-intentioned trades can quietly undo the tax benefit of a loss.
The wash sale rule: Under IRS rules, a loss is disallowed if you purchase the same or a substantially identical security within 30 days before or 30 days after the sale that generated the loss, a window of 61 days in total. The rule looks across all of the accounts in your name, not only the account where the sale occurred, and it reaches a spouse’s accounts as well. A particularly costly version of this trap is triggering a wash sale through a purchase in an IRA, which can cause the loss to be disallowed permanently rather than simply deferred. In most other cases, a disallowed loss is added to the cost basis of the replacement shares, which defers the loss benefit rather than eliminating it. Even so, the rule is unforgiving and easy to trip over without coordination across accounts.
Selecting the replacement investment carefully: To stay invested while avoiding the wash sale rule, any replacement must not be substantially identical to what you sold. The IRS has never precisely defined that term, so this is an area that calls for judgment: choosing an investment with similar exposure, for instance a comparable fund tracking a different index, without crossing the line into something substantially identical.
Short-term gains when rotating back: Investors often intend to return to their original investment once the wash sale window has passed. If the replacement has appreciated and has been held for one year or less, however, selling it to buy back the original generates a short-term capital gain, which is taxed at ordinary income rates that are higher than long-term capital gains rates. The very rotation meant to be tax-efficient can create a tax cost of its own.
Resetting the holding period: When you repurchase your original investment after the wash sale window has passed, a new holding period begins. If you later need to sell, you may again face higher short-term rates until you have held the position for more than a year.
Other considerations: It is important to remember that tax-loss harvesting defers tax rather than eliminating it. When you sell at a loss and later repurchase the investment at a lower price, you have a new, lower cost basis moving forward. That lower basis means a larger gain, and a larger potential tax, whenever you eventually sell. Because of this, the strategy only truly saves tax, rather than simply shifting it to a later year, when the loss offsets a gain that would be taxed at a higher rate now than the rate that will apply to the larger gain in the future. If your future rate is the same or higher, the benefit is largely a timing difference rather than a permanent tax savings. Beyond this, there is market risk during any period spent in cash or in a replacement holding, potential transaction costs to weigh, and potential state tax considerations depending on where you live. None of these are reasons to avoid the strategy. They are simply reasons to approach it deliberately.
The Bottom Line
Used thoughtfully, tax-loss harvesting can be a useful part of tax-aware investing. Pursued indiscriminately, it can trigger disallowed losses, unexpected short-term gains, and other tax costs that erase the intended benefit. Our view is that loss harvesting is a tool to be used selectively, when the circumstances genuinely warrant it. Chasing every available loss is a classic example of letting the tax tail wag the investment dog, and the unintended consequences described above are precisely why we are deliberate about when, and whether, to use it.
The points above are not meant to be a comprehensive treatment of the strategy, but they illustrate why the details deserve attention, and why working with an advisor who weighs them, including the decision of when not to harvest, can matter.
If you hold meaningful assets in taxable accounts and want to work with a firm that thinks carefully through questions like these as part of a broader, proactive financial plan, we would welcome a conversation.
Goodman Financial is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
