Tax Loss Time

This year's equity & bond market declines present ample opportunity for tax-loss harvesting

One silver lining about equity market declines this year is the ability to reduce future taxes. The process - tax-loss-harvesting - enables tax filers to reduce investment gains by the amount of losses.

If the losses exceed the gains, up to $3,000 ($1,500 for married filing separately) can be deducted from other income. Any additional losses can be carried forward to future years.

The strategy can help minimize tax liabilities but, as this Wall Street Journal article points out, there are details to be aware of.

A common one is the wash sale rule. This prevents selling a security at a loss, claiming the tax benefit, and buying the same - or “substantially” similar - security within 30 days of the sale. It is important to note it is really a 60 day window - from 30 days prior to 30 days after the purchase.

Per the IRS, “A Wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:

1. Buy substantially identical stock or securities,

2. Acquire substantially identical stock or securities in a fully taxable trade,

3. Acquire a contract or option to buy substantially identical stock or securities, or

4. Acquire substantially identical stock for you individual retirement arrangement (IRA) or Roth IRA

The common theme here is the term “substantially”. There is a fine line in certain situations as to whether two securities are substantially similar. And it pays to not make a mistake.

The IRS says, “stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, there are special cases where they may be considered similar, like the predecessor and successor securities of a merger, for instance.

Another point to be aware of is different security types of the same company. Bonds and preferred stock are generally not considered similar to the common stock of the same company. The exception to that rule is when there are convertible options or if the bonds or preferreds share other attributes with the common equity.

Wash sale rules apply to options, warrants, and short sales as well.

If a wash sale is triggered, the loss is not totally foregone. Assuming a loss of $100 from a sale, but a substantially similar security was acquired within 30-days (before or after), the $100 is added to the cost basis of the newly purchased security. The higher cost basis reduces the future tax liability when that security is eventually sold.

Tax loss harvesting is a good strategy if done effectively. A financial advisor can help you understand which securities to sell or not in the context of your overall portfolio. A tax advisor can help explain the full tax implications.

Selling just to reap the tax benefit may not always make sense. The sale needs to be considered from the portfolio perspective.

This is for informational purposes only. Not to be construed as tax or portfolio advice.