Many investors evaluate their portfolios at the end of the calendar year to identify stocks with losses that can be realized in order to reduce taxable gains for the year. The realization of these losses is referred to as “tax loss harvesting,” which is a useful strategy to reduce the tax liability owed.
While all investors should consult with their own accountants prior to making tax harvesting decisions, below are several factors to consider when harvesting losses for the year.
Capital losses offset capital gains, not ordinary income
A common mistake that investors make is to assume that realized losses from publicly traded stock can be used to offset their salary that is paid to them from an employer. The salary that is paid to an individual as a result of his or her employment is referred to as ordinary income.
The IRS looks at ordinary income as being in a separate bucket than capital gains and losses. For example, let’s assume that Larry earns a $100,000 salary. At the end of the year, Larry has an unrealized loss of $20,000 in his Facebook stock investment. Should Larry sell his Facebook stock in order to lower his tax bill?
Based on the prevailing tax laws in 2018, if Larry were to sell Facebook and realize the $20,000 loss, the IRS would only allow Larry to use $3,000 of this realized loss to offset his $100,000 salary. Therefore, Larry’s taxable income would be reduced to $97,000 and the $17,000 realized loss that was not used would be carried forward to subsequent tax years. In future years, the $17,000 tax loss carryforward can be used to offset ordinary income at the rate of $3,000 per year or offset realized capital gains.
Do you have realized capital gains that will be reduced by harvesting a capital loss?
Realizing capital losses is most useful when an individual has realized capital gains that can offset the capital losses. In our above example, Larry had an unrealized capital loss of $20,000 in Facebook. Let’s also assume that Larry previously sold Amazon stock for a $10,000 capital gain. Therefore, Larry has ordinary income of $100,000 and a $10,000 realized gain from his Amazon stock.
If Larry realized the $20,000 loss from his Facebook stock, then, the first $10,000 of this capital loss will be used to fully offset by the $10,000 realized gain from Amazon. Since $10,000 realized loss remains, $3,000 of this $10,000 unrealized Facebook loss can be used to offset ordinary income, resulting in taxable income of $97,000 and no capital gains. Larry will then carry forward $7,000 of unused taxable loss into future years.
Consider your long-term investment thesis and holding period before selling
Prior to selling all your stocks where you have unrealized capital losses, consider your long-term investment thesis for the stock that you are considering selling. For example, in our example, Larry has an unrealized capital loss of $20,000 in Facebook stock. If Larry believes that Facebook stock has 100% upside in the next twelve months, then, selling Facebook stock today may be short-sighted if Larry ends up missing out on substantial gains down the road.
Also, Larry should consider his holding period. If Larry has already owned Facebook stock for several months and he believes that Facebook stock has substantial future upside, then, Larry will be able to capture long-term capital gains once he has held the stock for longer than 12 months (assuming Facebook stock does indeed go up). Since long-term capital gains are taxed at a lower rate than short-term capital gains, Larry may end up in a better economic position by waiting for Facebook stock to go up and to realize capital gains at a long-term capital gains rate.
Harvesting a loss and then re-purchasing the same stock – avoid wash sales
Some investors may want to realize the capital loss on a stock but repurchase that stock since he or she believes that the stock will go up long-term. If an investor sells a stock for a loss and then repurchases the same stock within 30 days, the IRS considers this transaction a “wash sale” and will dis-allow the capital loss.
For example, if Larry sells his Facebook stock for $80,000 which had an original basis (purchase price) of $100,000, then, he will realize a capital loss of $20,000. After selling Facebook stock, let’s assume that Larry then repurchases Facebook stock 15 days later and redeploys his $80,000 of proceeds back into Facebook.
The IRS will consider this a wash sale and will dis-allow the $20,000 realized capital loss. The $20,000 loss will be added to the $80,000 basis of the repurchased Facebook stock to yield a new basis of $100,000. If Larry decides to sell Facebook down the road for $90,000 in proceeds, then, he will realize a capital loss of $10,000 ($90,000 proceeds minus the $100,000 wash-sale adjusted basis).