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“For many investors, tax-loss harvesting is one of the most useful tools for reducing capital gains taxes.”
When securities and certain other assets, such as real estate, are sold at a loss to offset a capital gains tax liability, the process is known as “tax-loss harvesting, “or “tax-loss” selling. Typically, investors use tax-loss harvesting to limit the recognition of short-term capital gains.
How Tax Loss Harvesting Works: Even in a bull market, veteran investors may find that they have added a few losers to their portfolios. Tax-loss harvesting may be able to lessen the pain of those stinkers by giving you the ability to use those losses to lower your tax liability. Your portfolio will then be better positioned in the future.
A tax-harvesting strategy usually works something like this:
Imagine you bought a shiny new tech stock that is now declining. You decide to sell that underperforming asset at a loss to stop the drain on your portfolio. You then take that loss and use it to reduce your taxable income gains. Potentially, you could offset up to $3,000 in ordinary income. Finally, you might reinvest the money from the sale into a different asset that better meets your needs.
Here’s an example of how this could work for a typical investment. Say you have a recognized gain of $10,000 on a stock purchase you made six months ago. Since you had that stock less than a year, the gain is treated by the IRS as a “short-term” capital gain. As you may know, short-term gains are taxed at significantly higher “ordinary income” rates than investments that are held for a year or more.
You decide to sell off shares of an underperforming stock that is draining your portfolio at around the same time. You sell that asset at a loss of $20,000. Your $20,000 loss would offset the entire $10,000 gain from the first stock purchase, meaning you won’t owe taxes. You could use the remaining $10,000 of the loss to offset $3,000 of your ordinary income. Anything leftover could be carried forward to offset your income in the future.
Some things to consider: If you are thinking of using a tax-loss harvesting strategy, you must be aware of some things.
Summing it up:
Tax-loss harvesting regularly and proactively can help many individuals, especially those in higher tax brackets. Using this strategy, you may realize losses and use proceeds from the sale to purchase other securities or safe money products, such as annuities. However, there are many rules, regulations, and pitfalls that you must understand before undertaking a tax loss harvest. You must also consult a tax professional to ensure that your tax-loss harvesting strategy is correctly designed and executed.
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