Investing always comes with some degree of risk, and the simple truth is that some investments don’t work out. While no one wants to take a loss, there is a benefit to a losing investment — at least when it comes to that individual’s tax burden.
As a tax professional, you likely have several clients who have made significant investments in stocks or other equities. If these resulted in losses, you can guide them through making the most of a non-optimal situation with a smart tax-loss harvesting strategy.
In this post, we’ll go over the basics of tax-loss harvesting, who can benefit from this practice and specific tax-harvesting issues and rules to keep in mind.
What is tax-loss harvesting?
The basic premise of tax-loss harvesting is this: to use investment losses to offset capital gains. Winning investments, or capital gains, come with a tax burden. However, any capital losses can be applied to that gain and reduce the individual’s overall tax liability.
Let’s go through an example. Say your client, Kara, purchased stock in a specific company for $12,000, then sold it for $20,000. That’s a gain of $8,000, which would be subject to taxation as capital gains. For most people, that tax rate is no more than 15%, so we’ll say that Kara owes $1,200 on her winning investment.
However, Kara also bought $12,000 of another company’s stock. Unfortunately, that investment decreased in value, and she ended up selling her stock for $10,000. That loss of $2,000 can be used to offset the full amount owed on Kara’s successful investment, aka her capital gains. Because $2,000 is greater than $1,200, she no longer owes that capital gains tax, reducing her tax liability under tax-loss harvesting.
What’s more, Kara can take that “leftover” $800 and apply that toward her regular taxable income. In fact, investment losses can be used to offset individual income up to $3,000 (or $1,500 for married couples filing separately), even if you realized no capital gains. If Kara had only made the one losing investment, she could still use it to reduce her taxable income.
Why tax-loss harvesting is important
Just about everyone wants their tax bill to be as small as possible, and tax-loss harvesting can help your clients reach that goal. With a lower tax burden, individuals are better equipped to put their money where it can do the most good, whether that be into another investment account, into savings, retirement or toward their day-to-day expenses.
It also allows individuals to balance their portfolio and make strides toward their investment objectives. For example, if a client has invested too heavily in one sector (tech, pharma, etc.) for their liking, they can sell those stocks or securities at a gain, then use that to reinvest in other areas. They can also sell stocks that no longer fit into their financial strategy or are performing poorly, then use those strategic losses to offset their capital gains.
Rules and issues surrounding tax-loss harvesting
Tax-loss harvesting is a helpful tax strategy for many investors; however, tax preparers should know that there are several rules governing its use. Plus, it’s not applicable in all situations. In this section, we’ll discuss a few of these tax-loss harvesting pitfalls and guidelines.
If your client’s losses were tied to a retirement account like a 401(k) or IRA, then tax-loss harvesting isn’t an option. Generally, you can’t deduct any losses tied to a tax-deferred account.
The wash-sale rule
According to the tax code, you can’t use an investment loss to offset capital gains or ordinary income if you purchased the same or “substantially similar” security 30 days before or after the losing sale. This is known as the wash-sale rule. For example, let’s say a client sold a stock that had decreased in value at a loss. Then, a week later, the same stock increased in price. The client purchased the stock again, hoping for another value increase. In this situation, the client’s initial loss could not be used for tax-loss harvesting purposes.
Just about any stock or security is subject to the wash-sale rule, including mutual funds and exchange-traded funds (ETFs). Basically, anything with a Committee on Uniform Securities Identification Procedures (CUSIP) code counts. Unfortunately, “substantially similar” doesn’t have a formal definition. It’s up to the investor’s (and their tax preparer’s) judgment to decide whether a particular security purchase is similar enough to trigger a wash sale.
Short- and long-term gains
An investment that an individual has held for more than a year is considered “long term,” while anything held for less than a year is short term. Capital gains on long-term investments are taxed at a lower rate than those on short-term ones.
When it comes to tax-loss harvesting, losses must first be applied to gains on a like-for-like basis. For instance, a short-term loss should be applied to a short-term gain and a long-term loss to a long-term gain. However, if losses still exceed your gains, then they can be used to offset gains of the opposite type.
As in our first example, any “leftover” losses up to $3,000 (or $1,500 for married couples filing separately) can be applied to your ordinary income, reducing your tax burden. Losses beyond that amount can also be rolled over to the upcoming tax year.
When to consider tax-loss harvesting
There are certain situations when tax-loss harvesting is an especially sound financial strategy. Here are four examples:
- Your client is moving into a different tax bracket
Whether your client is moving into a higher or lower bracket, tax-loss harvesting can help reduce their tax burden. If your client is expecting to be in a higher bracket in the coming year, they can use tax-loss harvesting now to lower their tax liability. If they expect to be in a lower bracket, they might be able to defer capital gains and either be taxed at a lower rate or use losses to fully offset their amount owed.
- Your client is nearing retirement
Gains in tax-deferred retirement accounts like a 401(k) or IRA aren’t taxed until the holder retires. When that happens, they might be taxed at a lower rate because the individual is now in a lower income bracket. Strategic losses might be enough to completely eliminate gains on these investments and significantly reduce the client’s tax liability.
- Your client invests only in individual stocks or ETFs
In general, gains and losses on individual stocks of exchange-traded funds (ETFs) are much easier to apply to a tax-loss harvesting strategy — at least for the everyday individual. Gains/losses related to mutual funds, however, are much more complicated.
- Your client had multiple losing investments
Even if your client realized zero investment gains over the current year and had only losses, they can still use up to $3,000 (or $1,500 for married couples filing separately) of those losses to offset their regular taxable income. Also, losses beyond that amount can be deferred to the following tax year.
Reduce your client’s tax bill
Tax-loss harvesting is a savvy strategy for investors, and as a tax preparer, you’re well-positioned to help them make the most of it. To stay up-to-date on the latest guidelines around tax-loss harvesting, explore our CE (continuing education) courses and seminars. Also, learn how to start and grow your tax business with Surgent Income Tax School.