Tax-loss harvesting — The upside of downside

Tax-loss harvesting — The upside of downside

  • During a market drawdown, it is worthwhile to consider strategies for using capital losses to your advantage.
  • Investments selling below their cost basis may be opportunities to harvest losses and offset taxable capital gains in your portfolio.
  • Given the requirements for claiming capital losses, it may be best to consult a tax professional.

Nobody wants investment losses, but it’s important to be alert when prices are down because of the possibility of improving portfolio tax efficiency. Market volatility can set the stage for tax-loss harvesting, which at its simplest, is a strategy to sell investments and realize a loss that can offset gains now or in the future. To execute the strategy, it’s important to know how capital gains and losses are calculated, as well as other specifics of the tax code.

Federal tax receipts are on the rise

($ in billions)

Federal tax receipts are on the rise

Source: U.S. Bureau of Economic Analysis.

Harvest when the market is ripe

Both the stock and bond markets have declined substantially in 2022 after reaching record highs in 2021. Most securities and investment funds are down, and many investors may have unrealized losses somewhere in their portfolio.

When an investment — such as a stock or a bond, a mutual fund, or an ETF — is priced below an investor’s adjusted cost basis, it’s possible to sell it and realize a capital loss. Once realized, a capital loss can be used to reduce taxable capital gains from the sale of other assets. The calculation involves totaling all gains and losses from asset sales, separating long-term capital gains for assets owned more than a year from short-term capital gains for assets held less than a year, and determining the appropriate tax rate on each.

Tax-loss harvesting may be an opportunity to improve the tax efficiency of a given portfolio. It’s important to consult a tax professional before making a move to be sure it makes sense in an overall investment program and to avoid potential wash sales.

Watch out for wash sales

Be aware that if you sell an investment, you cannot reverse course in short order. Under IRS rules, if you repurchase the same security or a related derivative, such as a call option, within 30 days, you cannot claim the loss. The IRS considers that a wash sale and will not allow the taxable loss.

Due to wash sale rules, tax-loss harvesting could affect your short-term portfolio allocation to specific stocks, sectors, or asset classes. If you want to continue to participate in the market, one way would be to purchase a different security in the same sector or asset class, or perhaps choose a diversified fund. In the case of replacing one fund with another, look for one in the same asset class or category, but with a different manager, strategy, or portfolio.

It’s especially important to consult a tax advisor when considering tax-loss harvesting with mutual funds. The key issue for the IRS will be whether the two investments are “substantially identical,” which is more straightforward with individual stocks, bonds, and options than it is with funds. A tax advisor can help you compare whether the two funds have different managers and different portfolios. Some advisors even take a detailed look at portfolio holdings for overlap, and even study the cost basis of holdings.

For more information about wash sales, read IRS Publication 550, Investment Income and Expenses (Including Capital Gains and Losses). Also, see more detail in Putnam’s investor education piece, “Using investment losses to your advantage.”

Long-term tax planning

A realized capital loss need not be used right away. When capital losses exceed capital gains, up to $3,000 in net losses (for married couples filing tax returns jointly) can be claimed to lower your income subject to tax. Amounts higher than the $3,000 limit can be carried forward to lower your income in future years (see IRS Tax Topic No. 409). This offers the possibility of more strategic tax planning.

Stay active in down markets

After a difficult first half of 2022 for markets, the challenges of high inflation, rising interest rates, slowing GDP growth, and geopolitical uncertainty might continue to weigh down markets. Keep in mind that even in down markets there are opportunities to stay active and consider strategies, such as tax-loss harvesting, that could be beneficial to long-term portfolio efficiency.

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