Making Lemonade with Tax Loss Harvesting

Making Lemonade with Tax Loss Harvesting

            While we are undoubtedly experiencing unprecedented times in our nation’s history, there is usually a silver lining somewhere.  With the unexpected spread of a new virus, financial markets have been in turmoil to say the least.  Yes, most portfolios are down, but the silver lining some active investors have been waiting for is to exit positions with limited tax impact.  In fact, many investors will probably take advantage of depressed values and “harvest tax losses.”  In other words, investors may seize the opportunity to recognize an unrealized loss in their investments.  Sure it sounds straight forward, but investors may want to proceed with caution to avoid running afoul of the wash sale rule imposed by IRC 1091.

Capital gain and losses background

Capital gains and losses can be either short term or long term.  Capital assets held for more than 12 months are considered long term.  Gains or losses are considered short term if the assets are held for 12 months or less.  This distinction is important because long term capital gains are typically taxed at a more favorable rate than short term gains taxed at ordinary income rates.

A netting process must take place before determining the amount of tax due.  Short term capital gains and losses for the year are netted against each other.  Then, the same is done for long term gains and losses.  Lastly, the net capital gain or loss is netted against the net long term capital gain or loss.  Up to $3,000 of excess capital losses can offset ordinary income.  Capital losses exceeding $3,000 are carried forward to future years.

Tax Loss Harvesting

As you can see through the netting process, capital losses can help reduce potential gains owed on capital gains.  You probably noticed the word potential was used.  This is because there is a chance some or all of a taxpayer’s capital gains are taxed at zero percent if one’s taxable income is low enough.  It is important to note, however, that capital gains are still counted toward adjusted gross income even if they are taxed at a lower rate, but this aspect is probably another blog post.

With a tax saving incentive, taxpayers could be tempted to sell an investment they like just to recognize an unrealized loss.  However, the IRS is smarter than that and has closed that loophole.  According to IRC 1091, losses are disallowed when a taxpayer purchases the same stock or security or a contract or options to purchase substantially identical stock or securities within a 61 day period including 30 days before and after the sale or disposition of said stock.

Example 1:  On April 1st, Ted has an unrealized loss of $10,000 on XYZ stock.  So, he decides to sell XYZ to potentially use the loss later in the year to offset any possible capital gains.  Ted actually likes the stock because he thinks its long term growth prospects are good, but he really wants to recognize the loss.  Unfortunately, he does not know about the was sale rules and purchases XYZ two weeks later on April 15th.  This transaction is considered a wash sale and the loss is disallowed.

Ted learned the hard way, but the following year he believes he found another loophole.  He finds himself in a similar situation with ABC stock, but this time, he buys the stock in his IRA the day after he sells at a loss in his brokerage account.  Revenue Ruling 2008-5 considers this to be a wash sale, too.

It is important to note that the old IRS Publication 564 states, “ordinarily, shares of one mutual fund are not considered substantially identical to shares issued by another mutual fund.”  However, this is about as much guidance that is given with regard to mutual funds and the wash sale rules.  Equally as unknown is how exchange traded funds are viewed.  This code section predates the advent of ETFs.  While it is to reach the conclusion that different mutual funds can truly be different given the fact that you have a manager that could be managing a fund completely different than its competitors.  Consider S&P 500 ETFs, on the other hand, two different providers could easily have substantially identical holdings.  Hopefully, the IRS will give guidance on how the wash sale rules applies to these vehicles rapidly growing in popularity.  If not, maybe Congress will amend this Code provision to catch up to the times.

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