At Oasis Wealth, we are looking for ways to minimize income taxes. In periods of market downturns or even market upturns, one strategy that is often suggested is tax loss harvesting. It can be a beneficial strategy, but its application can be misunderstood or even wrongly implemented at worst.
Capital Gains and Losses With Regards to Tax Laws
Knowing when to utilize capital loss harvesting is beneficial. First, we must start with understanding how capital gains and capital losses are treated under the tax laws. You likely understand that long-term capital gains are taxed at different tax rates than ordinary income (such as wages and interest income). Like ordinary income, capital gains are taxed based on tiers. If one’s income falls under a certain threshold, capital gains are taxed at 0%! That’s huge, and there are planning opportunities here that we can hold for another day. The next two tiers are taxed at 15% and 20%. (Also note that net investment income tax can also be applied at a 3.8% rate for those exceeding certain income levels and state income taxes may apply.)
If you have a capital loss, there is an ordering rule for applying those capital losses. In simple terms (and without getting into short-term versus long-term capital gains and losses), capital losses are first applied against capital gains. Thus, if you realize a $40,000 gain on the sale of some stock and a $10,000 capital loss from the sale of another stock in one year, then your net capital gain is $30,000. If it is indeed a net long-term capital gain, then it is generally taxed at the capital gains rates. Effectively, your “deduction” for this capital loss was applied at the lower capital gains rates. If realized capital losses exceed capital gains in one year, then you can offset a portion of such losses against your ordinary income. Unfortunately, this offset against ordinary income is limited to $3,000 per year. Any unused losses (i.e., those that exceed the $3,000 limit) can be carried forward until such losses are used up. The same ordering rules apply to these carried forward amounts. Unlike many tax thresholds, the $3,000 capital loss limit is not inflation-adjusted.
Taking losses against capital gains can be advantageous in a few respects. First, the losses may allow you to avoid recognizing the gain at a higher tax rate. The loss may reduce a portion of your gain to a lower tax rate, e.g., going from the 20% tax rate to the 15% tax rate or from the 15% to a 0% tax rate. Second, taking losses may allow you to take advantage of other tax breaks (deductions or credits) or minimize financially-related penalties by reducing your (Modified) Adjusted Gross Income or Taxable income to a certain threshold. For example, those in their Medicare years might be trying to reduce the penalty associated with the Income Related Monthly Adjustment Amounts. Taking losses against large gains could help minimize this penalty. Third, minimizing income taxes earlier has a time value of money benefit – the more you can delay any kind of outlay has the potential to produce a compounding effect over the long-term.
Offsetting losses against ordinary income can be even more beneficial considering the generally higher ordinary income tax rates compared to capital gains rates. For example, at a certain income level you might be in a 15% capital gains rate but in a 32% ordinary income rate. This is what I call tax arbitrage. Let’s say you utilized a $3,000 loss against capital gains, then that saved you $450 in taxes that year (after applying the 15% capital gains tax rates). In contrast, if you were able to take this $3,000 loss against ordinary income, then that would save you $960 in taxes in this example (after applying a 32% tax rate). While one might say that the tax savings is the 32% tax rate multiplied by the $3,000 loss, or $960, the better way to look at the value is the differential in savings, or $960 less the $450, or $510. Of course, you can derive the value from calculating the difference in tax rates (32% less 15% = 17%) x $3,000 loss. Of course, one key is understanding your relative capital gains rates and ordinary income rates over the relevant period. We won’t review that here, but that is an obvious consideration.
The time value of money benefits would apply here, as well. If you are able to minimize your cash outlay due to this savings earlier rather than later, that could produce some returns on your savings over the long term. If you were able to recognize losses over many years, these benefits can add up. Of course, if you have to recognize losses for many years, then that likely means your investment performance has not been great. (Over the long-term, our goal should arguably be to increase our income which will generally lead to paying more in taxes. Losses are not something to be strived for!)
Impact Of Harvesting On Tax Basis
What many people fail to realize or take into account – and what some advisors fail to truly disclose to their clients when talking up this strategy – is the impact of this strategy on tax basis. When you sell an asset at a loss, the basis of your overall portfolio decreases. For example, let’s say you held stocks worth $200,000 and the basis was $150,000. You have an unrealized gain of $50,000. Let’s further assume you held Coca Cola stock in that mix of stocks that had a value of $10,000 and a tax basis of $13,000. Let’s assume you sold the Coca Cola stock and realized the $3,000 loss. Ignoring the tax benefit and any transaction costs, what is your new basis and unrealized gain? Your original basis was $150,000. You sold stock that had a basis of $13,000 but reinvested the proceeds from the sale of stock, or $10,000. The basis decreased by the $13,000 basis but increased by the $10,000 reinvestment. Thus, the basis decreases by a net of $3,000. The new basis is $147,000 while the value is still $200,000. The portfolio no longer consists of the Coca Cola stock, but the value is the same. Thus, the new unrealized gain is $53,000 ($200,000 less $147,000). While you were able to take the $3,000 loss immediately, it’s not a free lunch so to speak. Eventually, that initial unrealized gain of $50,000 is preserved due to how the basis adjusts. In other words, many people suggest that this strategy arguably does not cut taxes, it delays them. I would rephrase it to say that this strategy does not necessarily reduce overall gain recognition, but it can still minimize taxes and defer taxes – both good things.
So, if the basis adjusts to where you will eventually have to pay taxes on the same amount of gain, is there any reason to do tax loss harvesting. Yes, for the reasons stated above: a) tax rate arbitrage, b) tax threshold planning, and c) time value of money. You do need to be careful that tax loss harvesting does not have unintended consequences going the other way. For example, if you take losses now with no real tax benefit, but it causes you to realize more gain in the future that results in a higher tax rate in the future or leads to ineffective threshold management, then capital loss harvesting is not recommended. Just like with many other tax strategies, knowing your situation over a multi-year basis and timing the strategies is warranted.
Other Things To Consider
Before I conclude, it is important to add a few other caveats. First, when deciding whether to buy and sell assets, the investment characteristics should be the primary factor. There is no doubt that tax consequences should be considered, but many mistakes have happened when investors focus too much on the tax consequences. Never take your eye off of the “investment ball”. Second, when implementing the capital loss harvesting strategy or any tax strategy, consider the transactional costs and the time required to implement this strategy.
Third, taxpayers should be aware of the wash sale rule. Without getting into too much detail, that rule prohibits taxpayers from recognizing the losses when they buy the same security they recently sold at a loss. Basically, this provision is meant to disallow a loss when your investments truly did not change. For the applicable time period, the tax code says it is within 30 days before or 30 days after the sale. Moreover, the laws say that any security that is “substantially similar” falls under this provision. Of course, there are many other details regarding this rule, but for now we just wanted to highlight it so that you are aware of it.
Thus, capital loss harvesting should be considered, especially during market downturns. It can produce economic benefits in the right situation, but there are certainly other tax strategies that are often more beneficial. If done incorrectly, implementing this strategy can backfire on you. In additional to capital loss harvesting, there are a host of other strategies to consider when trying to minimize capital gains taxes, and these strategies should be coordinated with your overall cash flow and financial plan. If you would like help with this or other tax strategies, you should search for a financial planner that has expertise in the tax arena as that has the potential to enhance your overall situation. At Oasis Wealth, our team of CPAs and financial planners would be happy to help.