It is the most wonderful time of the year. The time when visions of Santa Claus rallies dance in investors’ heads. And one last portfolio review can result in tax savings ahead of the least wonderful time of the year — tax season.
Although tax-loss harvesting seems like it should be naughty, it is actually a nice exercise in prudent tax planning. It renders investment losses into tax positives through the selling of losing investment positions (held outside of retirement accounts like IRAs). The resulting losses are used to offset any gains realized during the year due to trading activities, mutual fund distributions or even bond maturities. After neutralizing the tax consequences of those short and long term gains, losses may then be used to offset up to $3,000 in ordinary income. Any remaining losses are then carried forward for use in future tax years. (The IRS Web site has more on the subject here.)
The actual process of harvesting is quite simple; it begins with forgetting about taxes.
“Look at the fundamental investment decision first — don’t let the tax tail wag the investment dog,” says Michael E. Kitces, a certified finanical planner and director of financial planning for the Pinnacle Advisory Group in Columbia, Md. “Just because a security is down should not be the only reason for selling and generating a tax loss.”
This is not just good sense; it is also in keeping with the IRS rules regarding tax loss selling.
The rules regarding tax loss recognition are fairly straightforward — with a few gray areas. After all this does involve the Tax Code. Different tax experts interpret those gray areas differently. This is why it is best to gauge the philosophical leanings of one’s tax preparer before making any moves.
Rule #1: Have a Rationale
As Kitces suggests, there should be a defendable reason for initiating the recognition of the loss. Were the IRS to challenge it, the wrong answer would be: Your Honor, I did it for the tax loss. Fortunately, correct answers are not hard to come by. These would include: Wanting to improve growth prospects by dumping an underperforming stock for one with better earnings expectations; a desire for a higher income from a bond or mutual fund; or replacing a dog of a stock with an ETF to gain greater diversification to the sector. Rationales are easy.
Rule # 2: Keep it Clean
As agreeable as the IRS is about letting taxpayers ‘benefit’ from their investment mistakes, doing so is not as simple as selling a losing position and buying it right back to generate a tax loss. Once a security is sold, the taxpayer has to remain out of the security for 30 days. That window on re-entry remains shut for 30 days after a sale and for the 30 days prior—eliminating a pre-entry. If the position is replaced with a substantially identical security within that period of time, the loss is washed out — in tax jargon, disallowed — and treated as if it never happened. The disallowed loss will be added back to the cost basis of the repurchased security, raising its cost basis.
Because of this "wash rule" investors wanting to keep their money invested to maintain their asset allocation often swap into similar, but non-identical assets, at least temporarily, before buying the same security back.
For instance, an investor selling Merck at a loss may want to retain exposure to drug stocks. Concurrent with selling Merck, that investor may buy Pfizer or Eli Lilly or perhaps a pharmaceutical ETF instead. After 31 days, Merck may be repurchased without endangering recognition of the loss.
With bonds it is very easy to avoid the wash rules, says Larry Torella, a tax partner at Eisner LLP in New York. “Bonds offer more flexibility than stocks,” says Torella.
Even if the swap involves the same issuer — which is not ideal — as long as the coupon and maturity are different, the instrument usually has different risk characteristics and trades in a less similar way, making it substantially different enough.
“There is no black and white definition of what ‘substantially identical’ means,” says Torella. “Clearly if the security has a different issuer, it’s a home run — such as swapping GM for Ford. If a fixed income instrument has a different maturity, as when going from a short-term issue to a longer-term issue, it is probably still okay. The closer in maturity and coupon, however, the closer a taxpayer is to pushing the line with the IRS,” he adds.
However Justin Ransome, a partner in the tax office of Grant Thornton in Washington, DC uses a stricter interpretation. For instance, he would be uncomfortable with a client’s trading one ailing automaker’s issue for another stock or bond. Certainly moving from one mutual fund family’s S&P 500 Index fund to another’s would be problematic for Ransome, as would be moving into an S&P 500 ETF, despite its being a different type of security altogether.
Rule #3: Selling in a Personal Account and Buying in an IRA
Long an accepted practice, with a history of being touted in tax planning articles, selling a security for a tax loss in a personal account and buying it back in an IRA is a very gray area. The underlying presumption is that if account titles are different, it is okay. However, according to Ransome, this tactic may not be legit due to other prohibitions regarding trading among related parties and it is certainly not in keeping with the spirit of the tax law.
Other experts disagree since the IRS has been mum on the subject and after so many years still has not issued guidance or expressly prohibited it. They deem the maneuver okay. But before engaging in such a slight of trade, it is advisable to consult one’s tax advisor first regarding their stance.
While some advisers will annually review portfolios for their harvesting potential before the December 31 cut-off without prodding, many wait to be asked by clients. Asking is worth the call. Receiving one last opportunity to recognize investment blunders and move into the New Year with improved portfolio prospects and a lower tax bill is the only gift the IRS hands out during the holiday season.