Tax Loss Harvesting
Turning Portfolio Pain into Planning Alpha – Pt. 1
Many investors may find themselves sitting on unrealized losses in positions that have lagged or corrected. This presents an opportunity not only to offset the current year’s capital gains, but also to rebalance portfolios to better align with client goals.
Tax-loss harvesting isn’t just a way to benefit from down markets; it’s a proactive strategy that can generate measurable tax alpha* when implemented to a client’s strategy1.
*Tax alpha: Tax alpha is the excess after-tax return generated by actively managing taxable events within a financial strategy. In the context of TLH, tax alpha comes from reducing your tax bill today by realizing losses, reinvesting the savings, and letting that money grow, leading to a higher after-tax return over time
How it Works
When a security is sold at a loss, that realized loss can offset other capital gains for tax purposes. If losses exceed gains in the taxable year, up to $3,000 can be used to reduce ordinary income2. Additionally, unused losses carry forward indefinitely. For example, if losses were to exceed gains by $4,000, $3,000 could be applied against current-year income while the remaining $1,000 could be saved indefinitely for subsequent periods1.
To stay invested and maintain market exposure, advisors or investors typically replace the sold position with a similar, but not identical, holding. This maintains exposure while simultaneously resetting the cost basis. The choice of replacement holding is an important one as to ensure that the loss is not disallowed. Under the current regulations, a “wash sale” can occur when an investor purchases a substantially identical security within the 30-day period before or after harvesting a loss. Under the conditions of a wash sale, the loss from the sale of the original security is disallowed and added to the cost basis of the new security3. Examples of securities that the IRS considers “substantially identical” can include the direct repurchase of shares in the security, dividend reinvestments via DRIPs, and even the purchase of derivative securities (i.e., Call options).
Harvest Now, Benefit Later
Even when clients do not have gains in the current year, losses can still be harvested and banked for future use. Advisors and portfolio managers can use this proactively, capturing losses today to offset large gains that are anticipated down the line, such as:
- Future business or property sales,
- Roth conversions (offsetting up to $3,000 in ordinary income), or
- Selling a substantial holding in a single security for a large, realized gain.
TLH is not Just for Year-End Planning
While TLH can be a powerful, year-end tool, advisors should keep in mind that markets do not wait until December to correct. Some of the most tax-efficient portfolios harvest losses during the year to maximize deductions and minimize taxable gains1. Volatility throughout the year can create opportunities to realize losses and redeploy capital, especially when rebalancing or repositioning client accounts.
This also reduces the time pressure of trying to harvest everything in Q4, when advisors are already bogged down with meetings, RMD and charitable giving questions, and discussions of clients’ tax liabilities for the current year.
1 Michael Kitces, “What Advisors Need To Know About Tax Loss Harvesting: Scaling, Execution Challenges & Wash Sale Rules,” Kitces.com
2 Internal Revenue Service. Publication 550, 2023. Available at: https://www.irs.gov/publications/p550
3 Sheryl Rowling, “Wash Sale Challenge: What Is Substantially Identical?” https://www.morningstar.com/financial-advisors/wash-sale-challenge-what-is-substantially-identical
For Use with the General Public. Financial Planning and Advisory Services offered through Vicus Capital, Inc., a federally Registered Investment Advisor.
