Tax loss harvesting (TLH) refers to selling investments that are worth less than their original purchase price in order to realize (or “harvest”) the capital loss.  The realized losses can be used to offset certain income[1], resulting in a lower tax bill.  This strategy can be especially valuable for high-earners in the highest federal and state marginal tax brackets.

Our TLH process for client portfolios is as follows:

1. Every week (and often more frequently), our trader uses our portfolio management software to scan every tax lot [2] of every position in every client’s taxable investment account(s).[3]  Doing so identifies all tax lots that could be sold at a realized loss above certain pre-defined thresholds.[4]
2. Any positions that are potential TLH candidates are then screened for potential “wash sale” rule violations.[5]  Any positions with wash sales issues are removed from the list.
3. We then apply a client-specific lens to any remaining TLH candidates.  Before any potential trade is made, the client’s Wealth Advisor must approve or reject it after considering the client’s real-life situation.  If, for example, we know that the client is about to make a contribution to that account, and that we might want to buy the same position that is being considered for harvesting, it may be prudent to forego the TLH opportunity to avoid an inadvertent wash sale.
4. Assuming the TLH candidate clears all of the above hurdles, we execute the trade and realize the loss.[6]  It is critical that client portfolios remain fully (and properly) invested at all times, so the sale proceeds are reinvested in a temporary replacement mutual fund or funds or ETFs.  We select replacement mutual funds or ETFs that come close to replicating the original position[7], but not so close that we risk triggering a wash sale.[8]
5. After waiting the IRS-prescribed 30 days from the original harvest trade, the replacement fund is typically sold and the proceeds are re-invested back into the original fund.  We say “typically” because there is always a chance that the replacement fund increases sharply in value during the 30-day waiting period, in which case we would not necessarily want to sell the replacement fund and realize a large (short-term) gain.  In those instances, we may keep the replacement fund.  This risk of getting “stuck” is one reason why we only harvest positions above certain loss thresholds, as described above.

It is worth noting that TLH only defers taxes and does not necessarily avoid them.  Because the position that was harvested resets at a lower cost basis, the eventual gains from the subsequent sale should be higher.[9]  So the benefits of TLH are 1) the time value of this deferral, and 2) the fact that the realized capital loss can sometimes be used to offset ordinary income, which would have been taxed at a higher rate.

Tax loss harvesting adds tangible value by lessening the tax burden of investing.  Because TLH opportunities most frequently present themselves during market declines (such as the recent coronavirus market crash), the strategy can serve as a silver lining during scary markets.

———————————————————————————————————

[1] In any given year, realized losses can be used to offset capital gains, with capital gains taxes only owed if there are more gains than losses.  If there are more losses than gains, up to $3,000 of losses can be used to offset ordinary income that year, with any remainder carried forward indefinitely into future years.  Each year, the carried-forward losses are again used to offset capital gains and up to $3,000 of ordinary income.

[2] Positions have often been purchased on multiple discrete occasions over time.  Each time the position is purchased a new tax “lot” is created, with unique share count and cost basis information.  At any point in time, each of tax lot has different unrealized capital gains (or losses).

[3] Tax loss harvesting is only relevant for positions held in a taxable investment account, and not an IRA, 401(k), etc.

[4] We set thresholds defined by both absolute dollar and percentage losses.  In most cases, the realized loss would need to be greater than $5,000 and at least 5% of the amount sold in order to make the TLH worthwhile to the client.  We use different thresholds for positions that fall outside of our model portfolio but that clients might own for a variety of reasons (e.g., they bought it before they started working with Geometric).

[5] The wash sale rule was created to protect against investors potentially abusing TLH strategies.  A wash sale occurs when you sell a position at a loss and within 30 days before or after that sale you buy a “substantially identical” security.

[6] A record of all realized losses is maintained by the account custodian and is reported in the client’s year-end consolidated 1099 tax form.  We ensure that these losses are captured on the client’s tax return.

[7] We attempt to replicate both the original position’s asset class exposure and its “tilt” towards small cap and value factors.

[8] Because the original positions were selected for our model portfolio, the replacement fund(s) are, by definition, marginally less desirable to own than the original.  Whatever delta exists between the two represents a difficult-to-measure “cost” of the TLH process.

[9] This assumes that the position will eventually be sold (likely in retirement), which is not the case for all positions.  Some positions will be donated to charity, and some will be held until death (at which point they receive a step-up in basis when passed to heirs).  In either case, taxes are never paid on those gains.