Harvesting Losses Can Save On Taxes (Elaine Longer Commentary)

Loss harvesting is a vital part of tax-efficient investing. Loss harvesting simply means selling stocks, bonds, or other investments that have lost value and using the realized losses to offset taxable gains and income from other assets in the portfolio.

Naturally, loss harvesting is most attractive in a bear market. However, investors should be alert to the opportunity to capture losses in any market environment.

When the stock market booms, investors typically fixate on picking winners and protecting gains. This leads to asset turnover and higher taxes. Investors tend to overlook the value of managing taxes in the portfolio.

But tax containment is a simple and practical way to improve investment performance in good and bad markets. By reducing the capital gains and income taxes triggered when investments are sold, investors can improve after-tax returns without incurring additional risk. Every dollar saved on taxes is a dollar that can be invested to create more wealth over time. The longer an investor’s time horizon is, the more value astute tax management can add.

Several factors should be considered in the harvesting of losses:

• Tax rate treatment. Short-term and long-term losses are treated differently for tax purposes. Investments held for less than a year are deemed short-term. Short-term gains are taxed at the investor’s marginal income tax rate (up to 38.6 percent); long-term gains are taxed at a 20 percent rate. So a short-term loss is usually worth more when it can offset a short-term gain.

• Loss and gain proportions. First, the investor should match similar losses and gains. The normal procedure is to apply long-term losses to reduce long-term gains, and short-term losses to reduce short-term gains. Remaining losses are then matched to offset remaining capital gains. If there are still losses left after all gains are matched, those losses can be applied to reduce the investor’s earned income and interest income up to $3,000 in a single tax year. Beyond that, excess losses can be carried forward to future tax years, when they can be used to offset realized gains, without limit, or to offset income up to $3,000 annually. Matching losses requires analysis, planning, and coordination, especially if a portfolio has multiple assets that show gains and losses.

• Timing and tax year. Generally, any loss realized in a given tax year reduces gains for that same year. But it is important to note that the IRS has a “wash sale” rule that disallows a loss for any investment that is sold and repurchased within 30 days. When a losing investment is expected to rebound soon, the investor may be reluctant to wait 30 days to get back into it, fearing that the benefit of a tax reduction will not compensate for the missed advance. One way to capture the loss while maintaining the position is to buy another investment in the same industry group with similar risk and return traits. Another strategy is to double up on the investments intended for sale, then after the 30-day wait, sell the higher-cost tax lot.

• Cost basis calculation. Losses or gains reported depend on the acquisition price (cost basis) of the shares sold. Three methods are available to calculate cost basis. Different methods can be used within a portfolio, but the same method must be applied to all shares sold of a particular investment.

First-in, first-out (FIFO) is the IRS default method. This method assumes that the first share purchased is the first share sold. In an upward-trending market, FIFO usually renders the largest gain (and therefore the smallest loss) for the investor because the older shares were usually bought at a lower cost.

Another method is cost averaging. To use this method, an investor should calculate the average acquisition price for all shares of a particular investment.

The preferred method is to sell high-cost shares first. This method requires identification of each tax lot of shares and diligent recordkeeping, but it is worth the effort. When realizing gains, investors can minimize taxes and keep low-cost investments in the portfolio. When harvesting losses, investors realize a greater loss through the sale of fewer shares. Tax lot identification requires tracking the original cost of each share sold, without regard to time sequence. Although this involves detailed recordkeeping, specific identification helps investors reap larger tax savings sooner.

Investors should keep in mind, however, that all of these decisions will affect the aggregate cost basis of the portfolio. For instance, selling higher-cost shares will reduce gains and taxes. But the assets that remain will have a lower cost basis, which may create future tax liability. If the portfolio grows, the investor will face a higher tax bill when the remaining shares are liquidated. The good news is that money saved today can be invested today, with a reasonable hope of future profit.

• Asset allocation/investment policy. Loss harvesting can affect the character of the whole portfolio: the asset allocation, expected risk and return dimensions, and rebalancing strategy. Investors should remember not to let the tail wag the dog when it comes to minimizing taxes. Low taxes aren’t the ultimate goal of good portfolio management; wealth creation is. Tax-efficient techniques should always be evaluated in the larger context of the potential impact on the investor’s personal tax position, investment policy, and investment goals.

Elaine Longer, CFA, is president of Longer Investments Inc., an SEC-registered investment advisory company in Fayetteville. For more information, visit www.longerinv.com.