This past August when the markets went on their roller-coaster ride, we sprang into action. It has always been our modus operandi to transfer losses from the portfolio to the tax return, and this volatility gave us another opportunity. Industry-speak calls this tax loss harvesting. Here’s why we do it.
Capital gains are taxed anywhere between zero percent and 23.8% depending on the tax bracket you’re in. Realized losses can be used to offset realized gains. A gain or loss becomes realized when you sell the investment. Until then, it’s an unrealized gain or loss, also known as a paper gain/loss. Any losses that exceed the amount of capital gains realized in a calendar year can be carried forward until death, or used against ordinary income to the tune of $3,000 per year. In other words, these losses have some real value when it comes to taxes.
When we engage in tax loss harvesting, we don’t take your money “out of the market.” All proceeds from the sales are reinvested in a similar stock or investment in order to keep your money hard at work.
As mentioned above, loss carry-forwards don’t expire until death. This is important to understand. If you’re sitting on a big loss in an investment, you need to realize the loss and use it up before you pass, or you will lose it. This is because your heirs will get a step-up in basis, which means their cost basis in the stock becomes the fair market value on your date of death. An exception involves when one spouse dies, leaving the other spouse with the investment assets. There is no step-up in basis, but the loss carry-forward will go away upon the death of the spouse.
When markets get volatile, the natural tendency is to do something. Harvesting losses and transferring them to the tax return yields an asset with real value going forward. As we mentioned earlier, this asset can be used to reduce capital gains tax exposure and/or reduce your taxable income. Consider this making lemonade out of lemons. The loss has happened. Getting any value out of it should be attractive to an investor. Most of our clients don’t like paying taxes, so here’s one way we reduce their tax bill.