For a larger part of the year, you want to make sure you’re minimizing your losses as much as possible. But when tax season rolls around, those losses can actually help you out!
If you sell an investment at a loss during tax season, you’re allowed to use that loss against your gains. As well as, income on your tax returns.
This strategy – taking advantage of tax rules – is known as tax-loss harvesting.
What is Tax-Loss Harvesting?
To understand tax loss harvesting, you’d have to understand what capital gains are.
When you sell an investment and make some profit on it, you realize a capital gain. This is because your taxable income went up since you made some money.
Profit from investments you’ve held for no more than a year they tax at the regular income rate. But for investments you’ve had for a long time, the tax rate is actually the “capital gains” rate – which is often higher.
That’s why tax-loss harvesting works. Because if you sell one of these investments before the tax season rolls around, it’s no longer part of your income stream. Thus you don’t have to pay the tax you owed on the gains.
Taking Advantage of Tax-Loss Harvesting
Tax-loss harvesting is a way for people to reduce the amount they owe in taxes by selling their investments. That is, if you have higher capital gains, you’ll have high amounts to pay in taxes. By selling the investments you made those gains on, you no longer become viable to pay.
You can technically take advantage of tax loss harvesting at any time during the year. But most investors choose to do so around the end of the year when they start assessing their portfolio. And that will start to affect their taxes.
In fact, for many people, tax-loss harvesting is actually an important tool. Of course, you can’t go so far as to deduct more than the total amount of losses you made for the year. But you can deduct a fairly large amount (up to $3,000) and reduce the impact those losses had on your investments.
Tax-loss harvesting also can’t bring you back to your original position – the losses will affect you in some way, but the impact will be less severe. The tax loss strategy can actually be very helpful for tax savings.
Buying and selling any investments in your portfolio will undoubtedly affect the balance – the overall risk and return levels.
For most investors, portfolio curation is an important task that they spend a lot of time on. But if they sell their investments at the end of the year to offset capital gains, they affect their whole portfolio. That’s why most investors won’t just sell the asset. Instead, they look for one similar to it in terms of risk and return and replace it.
However, it is important to make sure you’re buying the replacement asset at a decent time and a decent price. If you end up buying an investment that’s ‘substantially identical’, then you can’t write off the loss anymore. This is called the wash-sale rule, and instead of making a wash-sale, it’s better to just hold onto your losses and not make the sale at all.
Avoiding Wash-Sale Rule
One way you can avoid the wash-sale rule is to use ETFs – exchange-traded funds. Exchange-traded funds are those that, as the name suggests, are exchanged for each other, rather than bought or sold separately. Since there are plenty of ETFs that follow the same index, they can replace each other, and you can avoid violation of the wash–sale rule at the same time.
That way, if you sell an ETF at a loss that tracks S&P 500, you can buy a different one to harvest that loss, and since they both track the same index, it’s easier to make the comparison.
What are Substantially Identical Securities?
The wash-sale rule mentions ‘substantially identical securities,’ and states that you can’t buy one within the 30-day period after making the sale of an investment. But what are substantially identical securities?
Securities that are issued by the same company or any derivative contracts on the same security are considered to be ‘substantially identical’. For example, you can’t sell shares you made a loss on, and then buy shares for the same company if you want to take advantage of tax loss harvesting.
Still, you never know what kinds of issues may arise, so it’s always best to wait for a month before you buy any replacement securities at all, lest you end up violating the wash-sale rule by accident.
How Much Tax-Loss Harvesting Can You Use in a Year?
As exciting as it is to have a rule that helps you reduce your taxes, there’s a limit to how much you can rely on capital losses and tax-loss harvesting.
Individual taxpayers can write off about $3,000 in losses each year. If your losses go beyond that, you can carry the excess amount to future years. That is, if you make a $9,000 capital loss, you can extend that to the next three years as well.
Tax-loss harvesting isn’t necessarily for everyone. For example, investors who make a lower income have a very low capital gains rate – and sometimes none at all – so it wouldn’t really make sense to trade in losers rather than winners.
Besides, tax-loss harvesting can also affect your portfolio if you’re not careful, so it’s always best to consult with a professional before you make any decisions about whether to buy or sell your assets.