Tax Loss Harvesting: A Good Idea That is Overrated?

Turning lemons into lemonade should be considered during the market volatility that we find ourselves in today. 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 is often misunderstood or wrongly implemented.

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:

  1. The losses may allow you to avoid recognizing the gain at a higher tax rate.
  2. Taking losses may allow you to take advantage of other tax breaks (deductions or credits) or minimize financially-related penalties by reducing certain key thresholds.
  3. Minimizing income taxes earlier may have a time value of money benefit.

Offsetting losses against ordinary income can be even more beneficial considering the generally higher ordinary income tax rates compared to capital gains rates. Of course, one key is understanding your relative capital gains rates and ordinary income rates over the relevant period.

There are a few caveats before implementing this strategy:

  1. Understand that taking losses also reduces your tax basis in the portfolio, and this can result in larger capital gains down the road. This can, in turn, lead to higher taxes in the future.
  2. When deciding whether to buy and sell assets, the investment characteristics should be the primary factor.
  3. Consider the transactional costs and the time required to implement this strategy.
  4. Be aware of the wash sale rule.

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 addition 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.

By Steve Martin, CFP®, CPA, JD, LLM
Nashville, TN