A Practical Guide to Tax Loss Harvesting for Financial Advisors

It’s April, the world is starting to turn colorful and warm again, your investment accounts have done well, and you’ve walked away with a profitable year. All is right in the world, until you sit down with your accountant and look at your capital gains for the year - “Wait, I owe how much in capital gains taxes…?” 

If someone told you to sell your losing investments for a loss, you might think they’re crazy - why on earth would you want to voluntarily lose money? However, selling investments for a loss is part of an effective tax-saving strategy called “tax-loss harvesting”. Through tax-loss harvesting, losing investments are sold at a loss with the purpose of offsetting taxable capital gains. 

Tax-loss harvesting works like this: 

• Losing investments are first strategically sold (or “harvested”) and, if desired, replaced with a similar security to keep you invested in the market. 

• When tax season rolls around, you only pay taxes on net capital gains, which is your realized capital gains minus your realized losses. The larger your losses are, the smaller your net gains become, and the smaller your tax bill will be. 

• If your realized losses exceed your realized capital gains, you may also use the excess realized losses amount to deduct up to $3,000 from your ordinary income. 

• If you don’t have any realized gains or you still have losses remaining after offsetting your gains and deducting $3,000 from your ordinary income, then those realized losses can also be carried over to offset realized gains in the future.

For example, your capital gains are $10,000 for the year and you want to minimize your capital gains taxes. You have one investment that is currently down $16,000, so you sell it for a $16,000 loss. During tax season, your net capital gains becomes $10,000 - $16,000, or -$6,000. Not only are you able to fully offset your capital gains, but you were also able to deduct $3,000 from your ordinary income. Because you have $3,000 leftover after deducting from your ordinary income, you can carry that remaining amount over to next year and deduct another $3,000 from next year’s ordinary income. 

Before you start selling all of your losing investments, there are a few considerations to keep in mind:

• Wash-Sales. The IRS will not allow you to claim a loss if you immediately repurchase the security or a substantially identical security, after selling all or part of it. This is called a “wash-sale”, which is formally defined as selling a security at a loss and then, within 30 days before or after the sale, you buy substantially identical securities, including options contracts. In the eyes of the IRS, doing so literally makes the transaction a “wash”. 

• Deadlines. In order to partake in tax-loss harvesting for the tax year, all transactions must be settled by December 31st. If December 31st falls on a weekend, then all transactions must settle by the closest business day prior to December 31st.

• State-Specific Rules. States govern themselves, and therefore may have their own rules and regulations around tax-loss harvesting. It is important to confirm your state’s laws and regulations regarding tax-loss harvesting before implementing it in your tax-saving strategies. 

Tax-loss harvesting can be an effective way to lower your tax bill. By strategically claiming losses on losing investments, you can lower your capital gains taxes and possibly your ordinary income taxes. Although tax-loss harvesting may seem straightforward, each investor has a different situation, and tax-loss harvesting can quickly become very complex. It is recommended to always reach out to a financial advisor or tax professional to see if tax-loss harvesting would be beneficial for your financial goals and to create a plan that works for you.