Tax-loss harvesting is a strategy investors can use to reduce capital gains taxes owed from selling profitable investments. A tax-loss harvesting strategy involves selling an asset or security at a net loss. An investor may use proceeds from a sale to purchase a similar asset and maintain the portfolio balance. To illustrate this point, an investor who owns Lowes [Ticker: LOW] at a loss could sell the position and buy a similar position, perhaps Home Depot [Ticker: HD], to maintain exposure to the sector. However, it is important that the investor be mindful of the wash sale rule which stipulated that the investor stay out of the first security for at least 30 days.
One of the biggest reasons passive investors seek to directly own individual securities while tracking an index (direct indexing) is the ability to unlock losses at the individual security level—something a fund cannot do—and potentially reduce their tax bill. In this note, we will contemplate tax-loss harvesting.
As we see in this video, there are many ways in which tax-loss harvesting can be employed and many “problems” for which it can be a tool when applied properly.
Wealthy clients will often acquire many different types of assets over their lifetimes. When a sale of an asset becomes appropriate, this sale may affect a client’s capital gain situation. At Avantia we work with our clients and their accountants to understand the existing capital gain situation, the current and future year’s capital gain expectations, and the capital gain exposure present on the balance sheet as well as consider the existing tax landscape and how that could potentially change in the future. We often find that our new clients have a long history of either not utilizing a proper capital gain strategy within their financial structure, use too much of it (potentially leading to higher fees), or have not used the various levers within the strategy to optimize it. This is most often the case when the wealth manager and the accountant are not in an active dialog.
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Depending on a client's residency, they could also be subject to taxes at the state level and local level. In these situations, it is important that your advisory team (Financial, Tax, and Legal) understand not only your current residency but any plans for changing this in the future. This can make tax-loss harvesting more valuable (in higher tax jurisdictions). If capital losses exceed capital gains for the tax year, up to $3,000 could be used to offset taxable income (IRS Topic no. 409). Any excess net capital loss beyond this limit may be carried forward to future returns, essentially becoming a "tax asset."
Tax Loss Harvesting is much more than selling the losses. Understanding the relative tracking error of the portfolio to its applicable benchmark, as well as minimizing the time out of the market are both vitally important to investment returns. After all, investing is not only what you make, it is also what you keep that really counts!
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