In a recent devotional I read, the writer started with, “Life is a series of battles and blessings, battles and blessings, battles and blessings, battles and blessings, battles and blessings…”. He extended this out for a few more written lines, and the point he made was memorable and profound: When we are in a period of battle, it is hard to believe that it will ever end. When we are in a period of blessing, we sometimes expect it will go on forever. However, life is not like that. There are battles and blessings, sometimes happening simultaneously on separate tracks.
This concept is ever true in our financial lives, specifically with the stock and bond markets. So far, 2022 has been a battle. The preceding few years (post-March 2020) were a blessing for investors. In periods of battle, there are many tactical and strategic decisions that we make as your investment advisor, one of which is to transfer losses from your portfolio to your tax return. Known as loss trading, this can offer a silver lining in down markets.
Before detailing this strategy, let us define some important terms related to loss trading:
- After-tax account – A brokerage account with after-tax dollars (a non-retirement account). The taxation is different with these accounts. With IRA accounts, you pay ordinary income tax on all monies withdrawn from the account. With after-tax accounts, the taxation is a function of when you sell, not withdraw. You also pay tax on dividends and interest whether you withdraw those funds from the account or not.
- Realized vs. Unrealized Capital Gains – If you purchased 100 shares of XYZ at $80 per share and it is now worth $100 per share, you have a $2,000 unrealized capital gain. You do not pay tax on unrealized gains. If you sell those 100 shares of XYZ, then that $2,000 gain becomes realized and you pay tax on that gain. Current capital gains rates are favorable (to most) in comparison to ordinary income tax rates.
- Cost Basis vs. Current Value – Cost basis is the value at which you purchased a security. Current value is just that, the current or market value. When we sell a security in your account, the realized gain or loss is determined by subtracting the cost basis from the current value.
- Net Realized Capital Gain/Loss – At the end of each calendar year, all your realized gains (and losses) net against each other. In the case of a net loss at the end of the year, the IRS allows you to claim $3,000 against your ordinary income. The remainder will carry over to future years without limitation. For example, if your annual net capital loss is $10,000, you can reduce current taxable income by $3,000 in this calendar year and carry forward $7,000 of losses to offset gains in future years.
- Wash Sale Rule – A wash sale occurs when you realize a loss by selling a security, then buying back that same security within 30 days. Since realized losses are a tax benefit, the IRS has a rule in place that states you cannot participate in a wash sale and receive a tax benefit for a loss.
Loss Trading Defined
A strategy where a portfolio manager sells a security in an after-tax account where the current value is less than the cost basis. The sale results in realizing a capital loss. The proceeds from the sale are quickly used to buy a different security (thus avoiding a wash sale), to ensure that the account stays fully invested to the account owner’s long-term investment mix (or asset allocation).
Here is a live example: Billy owns ABC Mid Cap Fund with a cost basis of $37,500. The current value is $30,000. We sell ABC, thus realizing a loss of $7,500. We then buy back $30,000 worth of DEF Mid Cap Fund. Billy gets the tax benefit of the capital loss, but still has the same Mid Cap exposure in his account.
Our research team has a stable of quality stocks and funds to utilize in your accounts. So, when we are in times of “battle,” we will be proactive in realizing losses, all the while keeping you fully invested in the market. When the ship turns, it tends to turn fast, and positive returns come quickly.
You can find a summary of your realized gains/losses in the P&A Portal – Reports – Realized Gains/Losses. As always, reach out with any questions about this topic.
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Pittenger & Anderson, Inc. does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. Additionally, the information presented here is not intended to be a recommendation to buy or sell any specific security. To learn more about our firm and investment approach, check out our Form ADV.
