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Tax-Loss Harvesting Comes With Hidden Risks

December 15, 2022
Many investors have incurred losses during 2022 and are on the hunt for opportunities to boost their returns before year end. A popular strategy to recover losses is tax-loss harvesting, the practice of selling assets that lost value to offset the capital-gains tax.

In this article, Lori Ioannou from The Wall Street Journal details the benefits and pitfalls of tax-loss harvesting.

ARTICLE HIGHLIGHTS:

Tax-Loss Harvesting Comes With Hidden Risks

Investors who are licking their wounds after incurring losses in 2022 due to market volatility are now looking for ways to boost their portfolio returns by year’s end.

One widely used strategy is tax-loss harvesting. This practice of selling some assets that have fallen in value and then using losses to offset capital-gains tax liability not only reduces your tax bill, but also can be used to rebalance your portfolio.

“This year there is a unique opportunity for individual investors to use tax-loss harvesting not only for stock losses, but also for losses they had in the bond and crypto markets,” says Sean Mullaney, a financial planner and CPA who runs Mullaney Financial & Tax Inc. in Los Angeles.

The S&P 500’s total return is minus 13.3% for the year to date through Friday. The Bloomberg U.S. Aggregate Bond Index market dropped 11.4% over the same period. The cryptocurrency market selloff, meanwhile, has wiped $1.74 trillion of market cap from that industry over the past 12 months.

Tax-loss harvesting is complex, and investors often get tripped up. Here’s how it works and where the pitfalls are.

The basics

Positions in assets that have declined in value in taxable investment accounts are sold to lock in losses for tax purposes. If the losses exceed the gains, the leftover losses can be used in future years to deduct against wages and other income. Under the Internal Revenue Code, single filers and married couples filing jointly can deduct up to $3,000 in additional losses in any given year to offset ordinary income. Married couples filing separately can each deduct $1,500 against ordinary income. Any remaining losses can be carried over and used in the same way in future years.

Here’s a specific example. Assume an investor in the highest tax bracket has realized $25,000 in short-term investment gains this year. He faces a 37% tax rate as well as a 3.8% net investment income tax on these gains resulting in a tax bill of $10,200. In 2022 he also made a bad investment that is worth $30,000 less than what he paid for it. He sells the money-losing asset before year-end to offset his short-term gains, eliminating the $10,200 tax bill. He still has $5,000 of the loss left over for which he can take $3,000 this year to reduce other income on his tax return and carry over the remaining $2,000 to future years.

Such losses can be carried over to future tax returns indefinitely until they’re all used up. But capital-loss carrryovers survive only as long as you do. They can’t be willed to heirs.

The strategy isn’t for everybody. “Individuals and couples in lower-income brackets need to examine it closely to see if it makes sense for them,” says Tom O’Saben, director of tax content and government relations at the National Association of Tax Professionals. That’s because taxpayers with income below certain levels—$40,400 for single filers or $80,800 for married couples filing jointly—could be in lower tax brackets for any short-term gains and potentially have a long-term capital-gains rate of 0%.

Beware the ‘wash sale’ rule

In deciding what to do with the money raised by selling assets, investors must be wary of the IRS’s “wash sale” rule, which states that an investor cannot sell an asset—such as a stock, bond, mutual fund—at a loss and then rebuy it, or a “substantially identical” asset, within 30 days before or after that sale. If investors do, they cannot take the tax loss write-off.

There is debate among financial advisers as to what constitutes a “substantially identical investment.” The IRS looks closely at the buy-and-sell transactions individuals have made during the tax-loss-harvesting process so keep this top of mind, they advise.

While some investors might think selling an asset like SPDR S&P 500 ETF (SPY) and replacing it with Vanguard S&P 500 ETF (VOO) is a valid swap, “I’d argue that both are passively managed funds that track the same index, and the investor could be at risk of violating the wash-sale rules,” says Paul Winter, a certified financial planner and president of Five Seasons Financial Planning.

One type of asset that is increasingly held by investors but not yet covered by wash-sale rules is cryptocurrency.

The rule doesn’t apply to crypto, says Stephanie Lee, a certified financial planner and founder of East Rock Financial Services in San Francisco, “because the IRS currently treats crypto as property, not as a security,” she notes. “But this can change in the future.”

Since crypto investors aren’t covered by the wash-sale rule, they can sell crypto holdings at a loss, use the realized loss to offset capital gains and then repurchase the same crypto asset they just sold to capture any uptick in price.

Meantime, don’t try to outsmart the IRS. Bob French, a certified financial adviser and director of investment analysis at McLean Asset Management Corp., in Vienna, Va., points out that the wash-sale rule applies not just to an individual’s trading but to everyone in that individual’s household and other accounts he or she has some amount of control over. If your spouse or a company you control purchases the security you just took a loss on, that triggers the wash-sale rule.

“Basically, the IRS doesn’t want you to be able to take a loss, and then turn around just move it to a different account,” Mr. French says.

Plan ahead

Replenishing your portfolio within wash-sale-rule limits can be a fantastic rebalancing tool, says Matthew Lincoln, a certified financial planner and enrolled agent in Frederick, Md. “But you must be careful and choose replacement investments in areas that meet your financial objectives.”

To avoid any snags, Jared Hoole, a certified financial planner in Burlington, Mass., suggests investors have a stable of replacement options for their portfolio before they sell any asset for tax-loss-harvesting purposes. “Otherwise, you could be left on the sidelines while you are figuring out what to do.” Also be aware of the transaction costs you will have to pay during this process, he says.

Above all, remember that tax-loss-harvesting decisions should not be made in a vacuum. Whatever you do taxwise shouldn’t jeopardize the health of your portfolio.

The biggest mistake you can make is to sell an investment that has upside potential in a down market just for tax-harvesting purposes and then regret it. As Mr. O’Saben points out, “It’s tempting to do panic selling in volatile markets, but don’t let the tax tail wag the dog.”

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AUTHOR:
Lori Ioannou
The Wall Street Journal

ILLUSTRATION:
Alex Nabaum





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