No, I have not yet begun to dip into the eggnog. I am talking about doing some tax loss harvesting in order to reduce your tax liability. What is tax loss harvesting? It’s selling securities at a loss in order to offset gains or ordinary income. Typically the focus is to take the short term losses in order to offset the short term gains that are taxed at the higher ordinary income tax rate. So here’s an example:
• You bought shares of a mutual fund for $10,000 and they dropped in value to $5,000. You have an UNREALIZED $5,000 capital loss.
• In other areas of your portfolio you’ve done spectacular and you have REALIZED capital gains of $7,500 which is taxable.
• So let’s say you sell your “loser” and recognize a loss of $5,000 and you reduce your taxable capital gains to $2,500. You hold the proceeds from the sale in a money market, and then buy back your “loser” after 31 days.
Sounds like a trick? It’s not but it is tricky. The Internal Revenue Service (IRS) will disallow the loss if you don’t wait 30 days. It’s considered a “wash sale.”
And if you don’t want to wait 30 days, you CAN purchase a similar but different security. It’s important that the securities NOT be substantially identical. While the definition of substantially identical has not been defined by the IRS, there are guidelines. Mostly it means that the there is a change in the economic position and risk exposure and that the underlying portfolio is different.
Some guides lines to follow would be:
• Make sure the issuers i.e. Vanguard vs. Fidelity are different.
• Replace an index fund with an actively managed fund and vice versa.
• Replace an index fund with another index fund only if there is some overlap in holdings, and the proportions of the holdings are different.
• Watch declaration dates for mutual funds. You don’t want to buy the mutual fund after the declaration date, the period that determine the owner who is to get the earnings distribution, and before the distribution is made. Essentially you would have “bought” the earnings distribution that would be payable to someone else.
So how do you determine if you will benefit from this strategy? Here are the first steps:
• Check last year’s tax return and confirm if you have any capital loss carryover. You’re limited to use only $3,000 per year. If so, any benefit will be forwarded to future years.
• Confirm that transaction fees and inconvenience justify the tax break.
• Consider that ultimately you are really deferring the gain and not eliminating the gain.
• Consider that if you are in the 10-15 % tax bracket that you don’t pay capital gains.
I have not described how to calculate capital gains/losses. IRS Schedule D and its instructions walk you through this process, but for more information, read Publication 550. And your overall tax situation should be considered, so see a professional tax advisor.
In no way should tax loss harvesting override or disturb your asset allocation, rebalancing and diversification plan. This is a strategy that compliments your asset allocation and rebalancing efforts. And, if it all seems too complicated, come see me and I’ll walk you through the analysis. That way, we can facilitate the conversation with the tax advisor, calculate your capital gains and losses, and fully enjoy the pleasures of turning losses into gains.