As the year draws to a close, many people start thinking about ways to lower their tax bills before December 31st. This time of year is particularly important for actions like 401(k) contributions, charitable donations, and, notably, capital gains transactions.

One popular tax strategy many investors use towards the end of the year is tax-loss harvesting, a method that helps them strategically adjust their portfolio by offsetting gains with losses. What does this look like? Let's dive in!

What are Capital Gains?

Before discussing tax-loss harvesting, it’s important to understand what a capital gain is. A capital gain occurs when you sell or trade a capital asset, such as stocks, bonds, or real estate, for more than you paid. Conversely, the difference is considered a capital loss if you sell an asset for less than what you paid. There are two types of capital treatment, and each is taxed differently:

• Short-Term Capital Gains: If you hold an asset for less than a year before selling, the gain is considered short-term. These gains are taxed at your ordinary income tax rate, which could be quite high depending on your income tax bracket. Short-term losses (also held less than a year) can also offset these gains.
• Long-Term Capital Gains: If you hold the asset for more than a year, the gain is long-term. These gains are taxed at different rates, which could be lower than ordinary income rates. On a federal level, the long-term capital gains tax rates are 0%, 15%, or 20%, depending on your income. Long-term losses (also held more than a year) can also offset these gains.

If you'd like a detailed refresher, check out my previous newsletter about capital gains here. ​

When it comes to tax planning, these short-term gains/losses and long-term gains/losses are calculated separately. These totals are then netted against each other. If the final result is a loss, you can deduct up to $3,000 from your taxable income ($1,500 if married filing separately). Anything over this amount would be carried over for the next tax season and beyond. This is where tax loss harvesting comes into play.

The Opportunity of Losses

There are many ways your losses can be used to your advantage. As I mentioned, the IRS allows you to deduct up to $3,000 in capital losses from your income each year. But you can also use these to offset your gains or future offsetting. So, let's look at a couple of examples of this.

Example 1: What happens if you have more gains than losses? You can use those gains to offset those losses and minimize the total impact of this sale from the gain:

Example 2: What happens if you have more losses than gains? The losses would offset the gains, and the remainder can be used as a deduction toward income:

Example 3: What happens if you have more losses than gains and more losses than permitted for a year's deduction? The losses would offset the gains, $3,000 can be used as a deduction for this year, and the remainder is carried forward to the next tax season or beyond:

Example 4: What happens when you have short-term and long-term gains/losses? The short-term gains and losses first offset each other, and the same is true for long-term gains and losses. These final amounts are then offset with each other. After offsetting, any remaining amount takes on the larger original category's character (short-term or long-term):

This strategy can be a powerful tool for reducing your tax burden not just for your income, but for your portfolio.

The Logic of Tax Loss Harvesting

You might wonder, “If I’m a long-term investor, shouldn’t I just hold my investments and not worry about selling?” The answer is: it depends. Adjusting with tax loss harvesting to your portfolio can accomplish goals such as:

1. Selling positions that no longer align with your goals
2. Selling positions that you want to reap gains from
3. Reinvesting proceeds in existing / new positions you want
4. Doing the above in a tax-efficient manner
5. And more

Tax loss harvesting doesn’t mean you’re selling out of your investing goals. Instead, you’re strategically selling losing positions to clean up your portfolio and refocus on the investments you believe in for the long haul. This allows you to benefit from the tax deduction while staying committed to your long-term investment plan!

Be Careful of "Wash Sales"

Utilizing losses as a deduction is great as long as it follows the rules. Specifically, it must adhere to one rule to avoid being categorized as a "wash sale."

This is when you sell a security at a loss and then repurchase the same or a "substantially identical" security within 30 days before or after the sale. If this happens, the IRS disallows the deduction for that loss, which means you can’t use it to offset your capital gains or reduce your taxable income for the year realized.

Example:

• Suppose you sell a stock on December 10th for a loss, but then you repurchase the same stock on December 30th. The IRS will consider this a wash sale, and you will not be able to claim the loss on your taxes for this year.

When a wash sale occurs, the disallowed loss isn’t gone forever. Instead, it is added to the cost basis (the amount you have invested) of the repurchased shares. While you cannot use the loss immediately to offset gains, it can still reduce the taxable gain when (if) you sell the repurchased shares.

Example: You sell a stock at a $20,000 loss and a $10,000 gain. You then repurchase this within 30 days. The $20,000 loss is disallowed, which means the full $10,000 gain isn't offset and therefore realized. Suppose the repurchased stock was bought for $10,000. The $20,000 loss is added to the cost basis of the new stock. Therefore, your new cost basis is now $30,000, not $10,000.

In an ideal world, most would prefer to avoid this outcome. The best practice is to be mindful of the timing to make these changes efficiently and compliantly.

Final Notes

Keep in mind that everything discussed can only be accomplished in taxable accounts like a standard brokerage account but not in accounts like a 401(k) or Roth IRA since they have tax-advantaged benefits.

As we approach the end of the year, it's important to consider tax-loss harvesting, make your plan more efficient, and potentially reduce your tax bill. It’s a smart way to offset gains and ensure that you’re maximizing your long-term financial plan.

Given the complexity, coordinating with a financial planner and a tax professional is often beneficial. Everyone’s situation is unique, and personalized advice is crucial to avoid unintended consequences. But once you get the right game plan together, it can be a great way to make your plan tax-efficient!

‍