Ah, autumn! The harvest season!
Right now, images of pumpkins, squashes, fall fruits, and overflowing cornucopias abound.
But what does this have to do with investing?
I'm glad you asked. This fall, as thoughts turn to wrapping up for the year's end, consider the idea of Tax Loss Harvesting.
Put simply, if you have investments that have lost value, you might be able to use them to avoid taxes on investments that did better.
Please allow me to explain.
Gains and Losses
When you buy an investment, the amount you paid for that investment is your cost basis (sometimes called tax basis).
If the value of your investment increases to a level above your cost basis, you have an unrealized gain.
If the value of your investment decreases to a level below your cost basis, you have an unrealized loss.
If you continue to own the investment, there are no tax consequences because all gains or losses are unrealized - they only exist on paper.
But if you sell an investment with an unrealized gain - that is, you sell it for more than your cost basis - you have now realized the gain, and it becomes a taxable gain.
Netting Out
Many investors simply look at their annual 1099, shrug their shoulders, and pay taxes on their realized gains, unaware that they might have avoided those taxes with a bit of planning.
The U.S. Tax Code allows an investor to net realized losses against realized gains in any given tax year.
For example, say you owned Investment A, which you sold, realizing a gain of $100. Let's also say you owned Investment Z, which you sold for a realized loss of $100.
You can net your realized loss against your realized gain to zero out the tax bill associated with the $100 gain on Investment A.
Now, let's take it a step further.
Harvesting
Let's say that your normal investing activities during the year lead to the following:
| Realized Gains: | $10,000 |
| Realized Losses: | $3,000 |
| Unrealized Gains: | $15,000 |
| Unrealized Losses: | $5,000 |
If you do nothing, you might end up paying as much as $1,400 in taxes on your net realized gain.[1]
But what about those unrealized losses? What if you converted them from unrealized to realized?
You could choose to sell the investments with unrealized losses, harvesting them to offset your realized gain.
Now the math is more favorable.
If you are able to harvest all of your unrealized losses, your tax bill could be lowered to as little as $400 - a $1,000 savings![2]
Considerations
Before you crack open your laptop to hunt for unrealized losses, a few notes of caution.
If you sell an investment and then turn around and repurchase that same investment (or a substantially similar one) within 30 days of the original date of sale, the sale is deemed a Wash Sale and the loss will be disallowed.
So be sure you have a substantially different investment in mind, or that you are willing to let cash sit around for 31 calendar days before you re-enter the original investment.
And speaking of letting cash sit around, know that you may miss a market rally (or correction) while you are waiting to rebuy positions that you used to realize losses. In other words, be prepared for some FOMO.
Lastly, consider transaction costs.
If you are paying trade commissions, those costs may outstrip your tax savings.
You may pay a trade commission when you sell and another commission when you buy.
Harvesting unrealized losses to offset realized gains can be a handy tool for managing your annual tax bill. But be sure that you are also considering factors like opportunity cost and trade costs before you jump in.
Baird does not provide tax or legal advice. Please consult your legal or tax professional for specific information. While Baird does not offer tax or legal advice, our Financial Advisors regularly work with clients' attorneys and tax professionals to help ensure that all phases of wealth management are addressed.
[1] Assuming a tax rate of 20%: $10,000 - $3,000 = $7,000 x 20% = $1,400
[2] Assuming a tax rate of 20%: $10,000 - $3,000 - $5,000 x 20% = $400