Tax Loss Harvesting: When “Bad” Stocks Make Money
Updated: Dec 28, 2020
How to lower capital gains tax and do it right
Fall is indeed a time for harvest. And if we are to think of your stock market holdings as a delightful little farm — some of your crops might have wilted, but cheerfully and diligently you harvest the wastes. On a good farm, Everything has value. Anyone who ever operated a spade professionally will tell you as much. So, while leaves are changing their glamorous colors, we might want to divert our attention to the brokerage accounts, investigate what debris we can salvage, why, and how.
Tax-loss harvesting is a term used to describe selling investments that plummeted in value during the year. Selling produces capital loss that you may use to offset existing capital gains, in turn reducing your taxable income. In the absence of gains, you can deduct $3,000 ($1,500 for a single/separate filer) and carry the rest to future years until fully utilized.
Short-term capital losses reduce short-term gains, long-term transactions play in their own pool. However, if after all is said and done, you still have short-term gains and long-term losses left(or vice versa), then you can use short and long-term pools to offset each other.
Why segregate in the first place? Tax rates. Harvesting is commonly used to minimize taxable short-term capital gains since this type is subject to ordinary rates. Which are often much higher than tax rates applicable to long-term gains.
In fact, long-term capital gains will not be subject to tax at all until your overall income (think wages, portfolio, retirement, etc.) reaches $40,000 for single taxpayers or $80,000 for married couples filing jointly, jumping to 15% thereafter, with a top rate of 20% kicking in at $441,450, single, and $496,600, married (tax year 2020).
In comparison, short term gains will reach 22% tax rate as early as $40,126 for single and $80,251 for joint filers (tax year 2020) and will continue to rise up to 37%. Naturally, investors look for ways to minimize short-term gains whenever possible.
A warning is due here, if you sell stock to realize a short-term loss, you cannot purchase a substantially identical stock within 30 days. The IRS treats that as a “wash-sale” and disallows the realization of the loss — all your harvesting efforts will be null and avoid. The tax law does not define substantially identical security, and while it is clear that buying and selling the same stock meets this definition, the rest is rather vague.
If you are contemplating harvesting losses, one of the perfect examples to illustrate substantially identical stock is dual-class transactions e.g. if you sell XYZ Inc. Class A shares to generate loss and purchase XYZ Class B shares within 30 days, this transaction will be designated as a wash. Wonder what companies have a “dual-class” share structure? Think Facebook Inc., Alphabet Inc., Berkshire Hathaway Inc., Pinterest Inc., Lift Inc., etc. This is not a catch-all example and not an exhaustive list, but you get the idea.
So how does IRS receive information on wash sales? If sale and purchase take place in the same brokerage account, the broker will flag wash sale and report it accordingly on Form 1099-B, which in turn is shared with the IRS.
Generally, brokers do not flag wash sale activity across various accounts e.g. you sell shares at a loss in your Vanguard brokerage account and then buy the same stock in a Vanguard held IRA (traditional or Roth). Attempts were made, IRS audits completed and rulings are quite clear — such transaction will be reclassified as a wash sale and you will be subject to interest and penalties in addition to back taxes. The negligence penalty might also come into play here. Spousal IRA or brokerage account will fall under wash sale rules as well. Similar logic will apply to accounts with multiple brokers.
Lastly, it seems that the easiest way to avoid wash sale is to wait 30 days, so why all fuss? There are a few instances when taxpayers inadvertently generate washes. It is likely to happen if you do not dispose of the stock in its entirety and automatically reinvest dividends on the remainder. Automatic repurchase within 30 days is highly likely in such a case. Investment structure and reinvestment in your retirement plans also might come into play here. Just something to keep in mind before disposition.
Farming losses takes skill, they are not weeds and proper care is necessary. While resurrection from a plummeting stock market is unlikely, tax loss harvesting might provide enough of a tax break to keep your annual liability down and free some cashflow for more adventurous trades.
Sources: IRS Publication 550; Rev. Rul. 2008–5; IRC 1091
his article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate for or applicable to specific circumstances. Consult a Certified Public Accountant before making any major financial decisions.