Tax loss harvesting can be an effective means of managing your taxes using your investment portfolio. While the practice should be managed with care, when done correctly, it can have a dramatic impact on your tax bill.
The timing of tax loss harvesting is a crucial element – there are various rules that must be understood and followed in order to get the benefit without creating additional problems.
What is Tax Loss Harvesting?
Tax loss harvesting is selling an investment near the end of the year in order to create a realized loss that can be used to offset any realized gains or ordinary income on your taxes. When you purchase an investment, such as a stock, and the price of that stock decreases, there is a loss.
Before the stock is sold, this loss is classified as an unrealized loss because the price of the stock may reverse, rising to ultimately create a gain. It is only after the stock is sold that the loss becomes realized and the loss may be used as an offset for other gains, having real tax consequences.
The practice of intentionally causing losses to become realized for the purposes of reducing taxes is called tax loss harvesting.
Why Should You Harvest Tax Losses?
Tax loss harvesting can be an effective practice if it is done carefully and within the proper overall context of the investment portfolio. While it is most commonly done at the end of the year as part of end of the year tax planning, tax loss harvesting can be accomplished at any time during the course of the year.
Your savings from tax loss harvesting will be based on your current tax bracket. You can see the impact that tax loss harvesting will have on your taxes using the tax calculator. Reduce your capital gains by the amount of the loss to see the difference in your expected tax due.
Don’t forget to make sure that the closing of the position is in keeping with the overall investment philosophy. For example, if you believe that the stock in question is on the verge of reversing, the lost profit that will result from selling the stock will more than offset the gain from the tax savings. Clearly this would not be a good choice, and yet it is one that may result if one attempts to harvest tax losses without care.
The Wash Sale Rule
One of the significant tax rules that you must be aware of is the wash sale rule. Under this rule, after a position is closed, it must remain closed for a minimum of 30 days in order for a new basis to be created. Prior to the introduction of this rule, you could simply sell a security at a loss and then quickly repurchase it as a new trade.
Now, if you repurchase the security within 30 days of selling it, the basis price used for calculating tax consequences reverts to the original price used. It is important to be aware that substituting a nearly identical security may not be sufficient to escape the wash sale rule. If the replacement security is essentially the same, the tax loss may be disallowed.
The other provision of the tax code that is important to understand is that in years in which a tax loss is substantial, there is a maximum allowable deduction: $3,000. If you exceed this amount, the capital loss may be carried forward into future years and used to offset future gains.