Layin’ It On The Line: Tax-Loss Harvesting Can Help Offset Capital Gains

What is tax-loss harvesting and will it work for you?

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. Short-term gains are, as you may know, taxed at significantly higher "ordinary income" rates than investments that are held for a year or more.

At around the same time, you decide to sell off shares of an underperforming stock that is draining your portfolio. 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, there are some things of which you must be aware:

* The IRS allows you to use investment losses to offset taxes on your ordinary income. This means that even if you have no capital gains, tax-loss harvesting could be useful in reducing your taxes.

* You cannot deduct losses in a retirement account, such as a 401(k) or IRA.

* There are restrictions on how you use specific types of losses to offset certain gains.

* Something called the "wash-sale rule" prevents you from getting a tax deduction for any security sold in a wash sale as defined by the IRS. Generally, it's considered a wash sale when you sell or trade a security at a loss, and within 30 days before or after that sale, you buy what the IRS defines as a "substantially identical" stock or security.

* Tax-loss harvesting is most often implemented at the end of the year, but it can also be done at any time during a tax year.

* If you earn less than $40,000 as a single-filer or $80,000 as joint filers, you won't owe anything on your long-term capital gains. So, tax-harvesting provides no benefits to you.

Summing it up

Tax-loss harvesting regularly and proactively can help many individuals, especially those in higher tax brackets. Using this strategy, you may be able to 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.

Lyle Boss is a member of Syndicated Columnists, a national organization committed to a fully transparent approach to money management. Boss Financial, 955 Chambers St., Suite 250, Ogden, UT 84403. Telephone: 801-475-9400.