Tax-Loss Harvesting: Capital Gains and Lower Taxes
Imagine if you could lower your taxes while growing your net worth.
That’s possible, thanks to tax-loss harvesting. What is tax-loss harvesting? And how exactly can you benefit from it?
Well, if you’re not familiar with this tax-saving strategy, allow me to quickly explain.
Tax-loss harvesting is the selling of investments at a loss to offset your capital gains tax. After all, it’s not just about your gross investment returns; it’s what you keep after taxes.
This article explores tax-loss harvesting and also covers capital gains and capital loss.
Tax-Loss Harvesting Rules
Let’s discuss the rules and basics of tax-loss harvesting.
Tax-loss harvesting (sometimes referred to as “tax harvesting”) is a strategy you can use for your taxable investment accounts. Retirement accounts, such as 401(k) accounts and IRAs, are only taxed when you take money out.
Also, you can use tax-loss harvesting as a strategy to lower your capital gains tax or regular income tax. Suppose you’re filing your taxes as a single person. In that case, you can reference up to $3,000 of your realized capital loss to offset your taxable income within one tax year.
A married couple, filing jointly, can also reference up to $3,000 per year in realized losses. A spouse who files separately can deduct up to $1,500 in one tax year.
Suppose your tax losses are greater than what you’re allowed to reference. If so, you can carry the surplus forward so you can offset future gains. This tactic is called tax-loss carryover, aka tax-loss carry forward.
Let’s say your tax loss was $5,500 for one tax year. If you’re filing as someone single, you can carry over $2,500 to offset capital gains for future tax returns. I’ll go into greater detail about capital loss carryover a little later in this article.
Here’s another tax-loss harvesting rule:
You cannot deduct a capital loss on the sale of stock to offset the capital gain of the same stock. If you were to do so, that would be considered a wash sale. This wash sale rule prohibits investors from rebuying an investment within 30 days of selling it for a capital loss.
Capital Gains and Losses Explained
Now that we’ve covered tax-loss harvesting rules, let’s discuss capital gains and capital losses, so you can better understand tax-loss harvesting as a strategy. Capital gains and losses are usually associated with stocks and funds, but they can also refer to other investments like real estate.
What Are Capital Gains and Capital Losses?
Let’s start with capital gains. A capital gain is when an asset increases in value. The IRS considers it “realized” once you sell the asset. That’s when you have to pay taxes for that gain.
Here’s a simple equation you can use to calculate capital gain:
Price You Sold the Asset – Price You Paid for the Asset = Capital Gain.
For example, let’s say you bought 100 shares of Stock A at $7.50 on March 16, 2019. In total, you paid $750. Two years later, on March 16, 2021, you sold all those shares at $18.25 each. In total, you sold your shares for $1,825.00.
Here’s how you would calculate your capital gain:
$1,825 - $750 = $1,075
So, $1,075 would be your capital gain, assuming no fees were associated with the purchase or sale.
But there are two types of capital gains: short-term and long-term. (You just read an example of a long-term capital gain.) I’m about to explain the differences between the two.
Short-term vs. long-term capital gains
A short-term capital gain is what you earn if you sell your asset within one year of purchasing it. If you were to do so, the IRS would tax it as regular income. That means they would take somewhere between 10% and 37%, depending on your tax bracket.
A long-term capital gain is what you earn if you sell your asset after holding it for a year or more. The IRS taxes long-term capital gains at a lower rate than short-term capital gains. For long-term capital gains, the tax rate is 20% or lower.
Now, let’s talk about capital loss.
A capital loss is when an asset decreases in value. But like capital gains, the change in value isn’t realized until after the asset is sold.
Here’s a simple equation you can use to calculate capital loss:
Price You Paid for the Asset – Price You Sold the Asset = Capital Loss
For example, let’s say you bought 75 shares of Stock B at $21.50 on July 8, 2019. In total, you paid $1,612.50. Two years later, on July 8, 2021, you sold all of those shares at $9.40 each. In total, you sold your shares for $705.00.
Here’s how you would calculate your capital loss:
$1,612.50 - $705.00 = $907.50
In this case, you would have a capital loss of $907.50, assuming no fees were associated with the purchase or sale.
But we’re not done talking about capital loss. You should know about the two types: long-term and short-term. Let’s discuss the differences.
Long-term and Short-term Capital Loss
A long-term capital loss is when you take a loss after selling an investment you’ve owned for longer than 12 months.
A short-term capital loss is when you take a loss after selling an investment you’ve owned for less than 12 months.
You just read an example (Stock B) of a long-term capital loss.
For tax purposes, the IRS treats both long-term and short-term losses the same.
What Is Capital Loss Carryover?
If you’re wondering what capital loss carryover is, Investopedia describes it as:
“The net amount of capital losses eligible to be carried forward into future tax years. Net capital losses (the amount that total capital losses exceed total capital gains) can only be deducted up to a maximum of $3,000 in a tax year. Net capital losses exceeding the $3,000 threshold may be carried forward to future tax years until exhausted. There is no limit to the number of years there might be a capital loss carryover.”
Capital Loss Deduction Explained
The capital loss deduction allows you to receive a tax break for claiming your realized losses. By claiming your realized losses, you can decrease the amount of income subject to capital gains tax. The result? You pay less in taxes. Legally!
Tax-Loss Harvesting Example
Now that we’ve covered capital gains and losses, here’s an example of how tax-loss harvesting works. That way, you can see how everything we’ve discussed so far ties together.
|
2020 Tax-Loss Harvest |
|
|---|---|
|
Original Purchase Cost |
$ 500,000 |
|
Current Value of Investment |
$ 350,000 |
|
Banked Loss on Investment |
$ 150,000 |
| 2021 Gain Sale | |
|---|---|
|
Original Purchase Cost |
$ 350,000 |
|
Current Value of Investment |
$ 500,000 |
|
Gain On Investment |
$ 150,000 |
|
Losses Banked: |
$ 150,000 |
|
Gain Recognized: |
$ 150,000 |
|
Capital Gains Recognized: |
$ - |
|
Capital Gain Tax Avoided: |
$30,000 |
As you can see from this example, tax-loss harvesting can save you a bundle of money — $30,000, to be exact. Indeed, you get to keep much more of your money when you know how to offset capital gains.
Now, you’re probably still wondering, “Should I use tax-loss harvesting?”
Let’s examine further.
Should You Use Tax-Loss Harvesting?
You shouldn’t do tax-loss harvesting if you’re operating without a clear strategy. I wouldn’t recommend selling an asset just for tax reasons.
Before selling an asset at a loss, you should first inspect the company’s financials to determine its health. Is the stock price low because of the whims of the market? Or is it low because the business is floundering?
The worst thing you want to do is sell your stock in a lucrative business (that has long-term potential) at a loss.
But remember this:
You don’t have to make these decisions alone. A financial advisor can analyze your situation, sort through your portfolio, then create a holistic financial structure that can set you up for success.
Contact us and you’ll learn more.
Using Tax-Loss Harvesting to Your Advantage
By now, you’re aware that tax-loss harvesting can lower your capital gains tax, and that the best way to follow this strategy is to use the capital loss from sinking assets to offset your capital gains.
Here’s just a summary of the benefits of tax-loss harvesting:
Enhance after-tax returns
Provide the flexibility to rebalance your portfolio (Rebalancing your portfolio can help you minimize risk)
Carry losses forward (You can use your capital losses from one year to offset future capital gains, decreasing your taxes)
Grow the value of your portfolio (You can use the money that you saved from tax-loss harvesting to buy more assets)
It boils down to this:
The best way to take advantage of tax-loss harvesting is to understand your financial structure and how the markets work. That way, you can strategize using a calm mind, instead of having distracting emotions, like fear and worry, guide you.
But if you need a caring guide to point you in the right direction, you can talk to a wealth advisor.
A financial advisor can show you the value of playing the long game.
A Large Sum of Savings
Tax-loss harvesting is one of many strategies that are within a household’s financial control. This powerful strategy can produce a large sum of savings, but without the creation of a household’s financial structure, you could fumble this tax-saving strategy — or even completely miss out on it.
If you’re thinking about partnering with an advisor who will help facilitate a financial structure and have the necessary expertise to take advantage of all the “little” wins that compound over time, allow us to help you unlock the full potential of your wealth.
