Why Tax-Loss Harvest Your Portfolio?

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The first quarter of 2020 offered a rare opportunity to discuss some planning techniques that occur when markets experience a severe pullback.

Market volatility can be used to reduce taxes with “tax-loss harvesting” transactions. Tax-loss harvesting works by taking advantage of investments that have declined in value, which is a common occurrence in broadly diversified portfolios. By selling investments that have declined below their purchase price, a tax-loss is generated, and that loss can be used to offset other taxable gains, thus lowering your potential tax liability.

Given current market conditions such as these, Freestone looks for opportunities to take advantage of tax-loss harvesting for our clients. This planning opportunity provides losses to offset portfolio gains that may have been realized previously, or will be in the future. 

How does realizing the loss (selling the holding) benefit you? Let’s use the Vanguard Total Stock Market ETF (VTI) as an example. Let’s say you purchased 1,000 shares on January 1st of 2020 for $164.00/share for a total investment of $164,000. On March 18th, 2020, the shares traded at $119.00 a share for a total investment of $119,000. If you sold the shares, you would have realized a short-term capital loss of $45,000.[1] Because the shares were sold and the loss “realized,” the $45,000 can be used that year to offset certain other gains. If the applicable gains that year are less than the realized losses, you can “carry forward” the remainder of the loss into future years until it has all been used, allowing you to take full advantage of the loss . An individual in the 35% tax bracket would be able to reduce his or her tax bill by roughly $15,750 if there were other short-term capital gains created in this tax year or in the future.

This sounds great from a tax perspective, but aren’t we supposed to “buy low and sell high?” Yes! We want to remain long-term investors and can repurchase the same exposure of $119,000 in a similar (but not identical) strategy as a placeholder. This approach is necessary to comply with the “wash-sale rule,” which requires an individual to be out of the original investment for 30 days in order for the losses to count for tax purposes. On day 31, we can sell the placeholder investment and repurchase VTI at its new market price. 

Let’s fast forward in a hypothetical scenario where we repurchase VTI after 31 days. Bear in mind that there is no way to tell how the market will perform, but for purposes of our simple example, let’s assume the price at the end of the year is $164/share. In this case, taking into account only price movement, you would have experienced a flat (albeit volatile) year of performance but, realized a significant tax benefit along the way.[2]   

A few important caveats to note:

  1. Tax-loss harvesting only applies to taxable accounts. Retirement accounts such as IRAs and, 401(k)s, or 529s are already tax-sheltered and any investment held within these accounts are ineligible.
  2. Tax-loss harvesting must be completed by Dec. 31st to utilize the tax loss for that year’s filing.
  3. Long- and short-term capital gains rules still apply, so it’s worth reviewing all of your investments to determine what makes the most sense to sell.
  4. If you are unable to offset recognized portfolio gains you are only allowed to claim a limited amount of losses on your taxes each year – $3,000 or $1,500 (married filing separately). Additional tax losses can be carried forward to use on future tax returns.   

As with all tax items, certain restrictions apply and due to individual circumstances, all tax strategies may not be available or ideal for everyone. We are not making any investment or trading recommendations, and you should not take any action without first discussing with your Freestone advisor alongside a tax professional.

[1] Note that you may also incur other costs and expenses in connection with this activity, such as trading commissions.  We have not included such items for purposes of this simple, illustrative example regarding the mechanics of tax-loss harvesting.

[2] The prices and performance in the below chart are purely fictional and used for illustrative purposes only.

Important Disclosures: Nothing in this article is intended to provide, and you should not rely upon it for, accounting, legal, tax or investment advice or recommendations. We are not making any specific recommendations regarding any financial planning or tax planning strategy, and you should not make any financial planning or tax planning decisions based on the information in this article. The intention of this article is educational, and it is intended only to discuss a few limited aspects of very complex tax planning strategy. This article is not a comprehensive or complete summary of considerations regarding its subject matter. Each individual is in a different situation and has different items to address, and the options in this article are not appropriate for everyone. Please consult your Freestone client advisor and a professional tax advisor regarding options specific to your needs.

Posted By: Stephanie d'Ippolito, CFP®

Stephanie d’Ippolito, CFP®, is our Managing Director of Financial Planning. She is passionate about helping people and believes that financial planning can be a valuable tool for clients to understand and solve their unique financial problems. She lives in Seattle with her husband and two dogs, Toby and Thurman.