Not every investment will be as successful as hoped for, but there are strategies that investors can use to turn these losses into tax benefits. Losses on investment can be used to offset capital gains and reduce your taxes. Even if you don’t have gains for that year, losses can still be used to offset future gains or income. A strategy that many investors use to offset capital gains now or in the future is called tax loss harvesting.
Tax Loss Harvesting
It’s possible to offset capital gains with capital losses experienced during the tax year or carried over from a previous tax return. For U.S. investors, offsetting capital gains means you can lower your tax consequences. With tax loss harvesting, investors can sell securities at a loss to offset capital gains tax liabilities. If losses exceed gains, taxpayers can use up to $3,000 a year to offset ordinary income on federal income taxes. Here is how tax loss harvesting generally works:
- The taxpayer sells an underachieving investment at a loss.
- The taxpayer then uses that loss to reduce taxable capital gains. It’s possible to offset up to $3,000 of ordinary income each year if losses surpass gains for the year. This can continue to be carried over each year.
- The sold asset is usually replaced with a similar asset to maintain the portfolio’s asset allocation and expected risk and return levels.
Let’s look at an example of tax loss harvesting. You make a profit of $25,000 on Asset A, but Asset B is down by $10,000. Selling Asset B at a loss can offset gains from Asset A, and you’d owe taxes on $15,000 instead of $25,000. By harvesting the $10,000, you can use these proceeds in a similar investment to maintain a similar asset allocation.
Using the same example, what if Asset B is down by $45,000? In this scenario, your capital loss is greater than your gain for that year. If you had no other gain, you can offset your entire gain from Asset A and deduct $3,000 from your ordinary income to reduce your income tax.
Beware of Wash Sales
A wash sale is a transaction where the taxpayer sells securities at a loss at the end of the calendar year and buys identical securities within 30 days before or after the sale to maximize tax benefits and claim a capital loss on taxes. The wash sale rule is a regulation implemented by the IRS that stops taxpayers from abusing the system and benefiting from a tax deduction for an asset sold in a wash sale.
Taxpayers want to avoid participating in a wash sale by not buying securities that the IRS would consider “substantially identical.” In other words, don’t buy stock back within 30 days before or after the sale in the same company.
There’s no guarantee that tax loss harvesting will achieve expected results, but you can potentially reduce the sting of a loss by offsetting your capital gains with capital losses through the tax loss harvesting strategy.
Keep in mind that the amount of time you’ve held an asset is key: short-term losses are deducted against short-term gains, and long-term losses are deducted against long-term gains. Consulting with a tax professional and your financial advisor can help keep you on track towards reaching your investment goals.
The Investor's Cap Gains Guidebook
Re-invest your capital gains. Defer or Eliminate Taxable Income.