Harvesting the Loss: When Does It Make Sense?

At Bragg Financial, we ask ourselves certain questions repeatedly throughout the year: Should we harvest our client’s losses? For which clients does this make sense?

We go through this exercise on a client-by-client basis and often reach the same conclusion: We really shouldn’t harvest large amounts of losses for the sole purpose of reducing capital gains unless our client has a large realized gain outside of their Bragg Financial investment accounts that cannot be avoided. For example, it will likely make sense to harvest losses if you have a real estate or business sale or transaction with an unavoidable large gain in the current tax year.

What is a tax loss and how does it get harvested?

When an investment is valued at less than your purchase price—the cost basis—you have an unrealized loss. If you sell this investment, it becomes a realized loss and can be used to offset realized gains in the same tax year. Another term for realizing this loss is “harvesting the loss.”

In the event you end the year with more losses than gains, you can utilize $3,000 of the remaining loss to offset ordinary income and continue to carry forward the remaining loss in future years. If you are a single taxpayer and pass away with a carry-forward loss, it can be used to the extent of normal rules on your final income tax return, but the remainder is lost and can’t be passed to your heirs. If your tax filing status is “married filing jointly,” the factors that impact the ability to continue to use a carry-forward loss after the first death are a bit more nuanced and beyond the scope of this article.

Example: You own a stock valued at $10,000, but you paid $25,000 for it originally. If you sell it today, you will recognize a loss of $15,000. This loss can offset realized gains, thereby reducing your tax in the current year. It sounds too good to be true. Why not do this every year with every unrealized loss?

As with everything that sounds too good to be true, there are a few words of caution:

Wash Sale Rules

• If you sell a stock and buy it back within 30 days, the IRS wash sale rule applies, disallowing the loss for tax purposes.
• Your team at Bragg Financial may not be aware of purchases made in taxable accounts held elsewhere that could trigger a wash sale.
• The IRS may also consider a purchased ETF or mutual fund “substantially identical” to the one sold, which can also trigger the wash sale rule.

Resets the Clock for Long-Term Capital Gains

• Investments held for over one year qualify for lower long-term capital gains tax rates.
• Selling a security and purchasing a new one resets the clock for capital gains—any gains realized within the first year are taxed at higher, short-term rates equal to ordinary income tax rates.

Deferring Gains, Not Avoiding Them

• Tax-loss harvesting lowers your cost basis in a new investment, which increases your taxable gain when you eventually sell.

Let’s build on the earlier example. Assume ten years have passed since the value of the stock for which you paid $25,000 dropped to $10,000. Now your original stock, or the one you replaced it with, is worth $50,000.

• If you didn’t harvest the loss and held your stock with a cost basis of $25,000, you’ll trigger a realized gain of $25,000 when you sell the stock at $50,000.
• If you harvested the loss by selling the stock at $10,000, you created a $15,000 loss. When you reinvested this cash into a new holding, your new cost basis became $10,000. When you later sell the stock now valued at $50,000, you’ll create a realized gain of $40,000. Your net loss/gain between these two transactions is $25,000, which is the same amount had you not harvested the loss.

While many of us like to defer a tax as long as possible, a few things could happen since you are realizing $40,000 in gains at some future date instead of the $25,000 gain had you not harvested the loss:

• Capital gains rates could be higher in the future when you eventually sell the new holding. This could happen via tax reform or your personal capital gains tax rate.
• If you are age 65 or older when you eventually sell the holding, you’ll likely be on Medicare. Increasing your income in these years will contribute to IRMAA and you could be subject to higher premiums.
• If you continually harvest losses year after year, you’ll eventually end up with quite a few low-basis positions. Imagine the above example but compounded with several securities over 20 to 30 years. Keep in mind, if you have large IRAs,  your income in retirement can still be quite high once you are required to take required minimum distributions (RMDs).

All of this said, there are cases when a client has a large outside gain where tax-loss harvesting does make sense. In many cases, we can sell the stock at a loss and buy back a similar stock in the same industry or sector. For example, we can sell Lowe’s and buy Home Depot so that our client remains diversified across asset classes and sectors.

If there are other reasons to take losses, of course, we will do what makes sense for your portfolio. For example, we might trim a holding that is overweight or we may decide to hold a different stock in that sector due to the current company’s underperformance coupled with a dim outlook on future earnings.

If a client needs to raise cash for a draw, we might also consider selling those securities at a loss, as long as we can find ways to keep the portfolio in line with the asset allocation and diversified across asset classes and sectors. Ultimately, our priority is maintaining a well-diversified portfolio, rather than focusing solely on tax savings in any given year. A concentrated portfolio can be far more damaging over time than missing out on a single year’s tax benefit.

Of course, if you direct us to harvest losses after weighing the pros and cons, we can always do so. If you’d like to explore whether tax-loss harvesting is appropriate for you, reach out to your Bragg Client Advisor. We are happy to coordinate with your CPA, as they are the expert on your specific tax situation.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.