By FPA member Eric S. Toya, CFP®
Last Updated: October 3, 2011
Tax loss harvesting (TLH) is the act of selling securities (generally stocks or mutual funds) when they are down in order to realize the loss for tax purposes.
For example, say you purchased $10,000 of XYZ stock in January. By mid-year, XYZ lost half of its value and your shares are only worth $5,000. You have lost money in this investment, but at this point it is unrealized. In the eyes of the IRS, nothing has happened. However, if you sell the stock, you will realize the loss of $5,000 which can be used for tax purposes.
What are the benefits to TLH:
- Losses may be used to offset realized capital gains, thereby reducing or eliminating capital gains taxes.
- If you have more realized losses than gains, you are allowed to deduct $3,000 of your realized losses against ordinary income. If you are in the 25 percent tax bracket, that’s a $750 saving.
- If your capital loss exceeds your capital gains by more than $3,000, the excess can be carried forward to subsequent years. This means that you can offset future capital gains or continue to take the $3,000 deduction each year until you run out of loss carry forward.
Using the above example of XYZ stock, you would be allowed to offset gains up to the full $5,000 of losses realized. If you did not have any realized gains this year, you would be able to take the deduction of $3,000 and carry forward the remaining $2,000 to next year.
Maybe you don’t want to sell XYZ stock because you think that it’s going back up. You may be thinking that you will sell today to realize the losses and buy it back tomorrow. If you did that, you would be in violation of the Wash Sale Rule. The Wash Sale Rule requires that you wait at least 31 days before buying the same stock or a “substantially identical” security. There is some debate as to what constitutes a substantially identical security, especially in the case of mutual funds.
One option is to simply sell the stock and wait 31 days before buying it back, holding the proceeds in cash while you wait the required number of days. Of course, the stock could go up during that time, and missing out on the gains may be worse than gaining a tax deduction.
Another strategy you may consider is to buy another stock or mutual fund as a proxy. The idea is to buy a stock that may be in the same industry, or a mutual fund that buys similar companies. Be careful not to violate the substantially identical rules, thus creating a wash sale.
Tax Loss Harvesting can be a tricky, though beneficial, strategy during periods of volatile markets. Please consult your tax or financial planning professional to help you navigate this strategy.
FPA member Eric S. Toya, CFP®, is Vice President of Wealth Management for Trovena, LLC in Redondo Beach, Calif. Eric graduated from the University of Southern California with a BS in Finance and Accounting. Eric has been quoted in national publications, including The Wall Street Journal, Money Magazine and the Los Angeles Times.