Following the post-COVID stimulus hangover in 2022, the bull market has continued to run. One of the key factors was the Federal Reserve’s decision to
Tax-Loss Harvesting – A Silver Lining of Market Downturns, but Not a Silver Bullet
Published Date : July 25, 2019
Tax-loss harvesting has been a major topic of conversation the past few years as strong equity returns have left portfolios with sizable unrealized gains. Opportunities to offset capital gains have presented themselves, as witnessed by last year’s severe market decline in December and the resulting frenzied activity to capture losses. While offsetting capital gains with capital losses usually makes good sense, it’s important to separate the benefits from the misconceptions and to understand that there are some potential risks. As with most good things, one approach does not fit all. Let’s step back for a moment to understand the basic pros, cons and misconceptions surrounding the strategy.
Harvesting losses is the colloquial term for the process of selling securities with current losses to tactically offset any realized gains taken in a given calendar year. The IRS allows this practice to occur as long as the security sold is not repurchased within 30 days of the sale date. This is known as the wash-sale rule. One approach followed by many investors wishing to maintain existing allocations while avoiding triggering the wash sale is to replace the sold security with a similar, but not identical, position in order to retain investment exposure during the 30-day period. This process of offsetting gains with losses is typically beneficial because it enables active portfolio management while serving to smooth out gains and losses from one year to the next, reducing the impact from high appreciation years, such as the above-average returns experienced in 2017.
It is important to acknowledge that some benefits are commonly inferred, but not always factual. For example, harvesting losses does not necessarily eliminate all taxable gains, but rather defers it into the future. While tax deferral is usually advantageous, since deferring taxes allows for the compounding growth of an investment, an individual’s tax bracket can vary significantly from year to year and potentially offset this assumed advantage. That is, at times it might be more sensible to simply realize the gain rather than possibly deferring it to another tax year. Also, tax-loss harvesting carries some inherent risk that the replacement investment used during the 30-day holding period is inferior. Replacement securities cannot be identical and therefore can potentially perform quite differently than the intended long-term investment. A related current dilemma facing some who aggressively harvested losses at the end of 2018 is how to address the significant market rebound since then. For those investors who simply harvested losses and opted to wait 30 days without investing in any replacement investment, they likely missed out on the strong rally in the first few weeks of 2019. For others who harvested losses and purchased proxy positions for the 30-day period, the decision looms about whether or not to sell the substitute positions, thus realizing short-term gains, or just continue to hold them for more than one year to enable more favorable long-term capital gain tax treatment, but risk possible underperformance along the way.
At Sand Hill, we generally believe that modest and opportunistic harvesting throughout the year can potentially be beneficial to smoothing out the variable year-over-year impact of capital gains; although we also take into consideration any specific significant tax-loss carryforwards or coming expectations of high tax years in the near future. Typically, tax-loss harvesting should not be done automatically or pursued too aggressively, because this can result in overly frequent trading without proper financial and tax planning input. Be cautious of oversimplified or overstated benefits of tax-loss harvesting, and always discuss the matter with your professional team.
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