Tax-Loss Harvesting: Turn Your Investment Lemons Into Tax Lemonade
8 min read
With the market volatility this year, I thought it prudent to share a sparingly used strategy that has the possibility of turning your investment lemons into tax lemonade. As you'll learn below, this strategy is highly individualized. Between the time-intensity and lack of scalability, many advisory firms do not implement this for their clients. As always, this is not intended as tax or investment advice and should be relied on for informational purposes only. Enjoy!
What is tax-loss harvesting?
Tax-loss harvesting is an investment strategy whereby you seek to maximize your after-tax results. This strategy can minimize taxes you may owe on your capital gains or regular income and can invariably improve your future after-tax returns. Ostensibly, this may seem counter-intuitive because you are selling something at a loss for a tax write-off and could miss out on future gains. But not so fast; within the IRS tax code, a workaround exists that allows both immediate and future tax benefits without compromising much, if any, future return. While taking a tax write-off for losses may seem analogous to kissing your sister, we will take a look at a way to turn a negative into a positive.
What is a capital gain/loss?
A capital gain occurs when you sell an investment at a profit. On the flip side, a capital loss occurs when you sell an investment in the red or at a loss. While selling an asset at a loss isn't fun, the IRS does allow you to write off these losses against any other gains you realized during that year. Also, you can deduct these losses up to $3,000 against your ordinary income. It is a long-term gain or loss if held for over one year. Conversely, it is a short-term gain or loss if held for less than a year. Short-term taxes are calculated based on your ordinary income bracket, while long-term losses are computed using a more favorable rate, as depicted below.
Hypothetical example.
Let's assume you are married and in the 24% tax bracket with $20,000 in realized net capital losses during the prior tax year. When you file your tax return, you can deduct $3,000 against your ordinary income, effectively saving you $720 in taxes (3,000 x 24%). Yet, there is still $17,000 leftover in realized capital losses. These could be used in the future to offset capital gains or $3,000 each year against ordinary income. These losses would carry over indefinitely to future tax years.
“An investment in knowledge pays the best interest.”
What are the limitations?
Uncle Sam disallows any write-offs from the loss resulting in the sale of an investment against the gains of the same security- this is known as a wash sale. This rule makes sense; otherwise, investors would sell all of their positions carrying an unrealized loss at the end of the year to receive the deduction, only to turn around and purchase the same security back immediately. The IRS is wise to this thought process and restricts the repurchase of the security you just sold for 30 days. A lot can happen in those thirty days, most notably missing out on a potential rebound in price. However, the rule states that you can't purchase the exact same security, but you can buy similar security that is not "substantially identical." This leaves the door open to a massive tax-planning opportunity.
“The first rule of compounding: Never interrupt it unnecessarily.”
Source: www.portfoliovisualizer.com data. Sample illustration, not a recommendation to buy/sell listed securities.
Reviewing the graph above, two ETFs are depicted: iShares S&P 1500 ($ITOT) and the Vanguard Total Stock Market Index ($VTI). From January 2020 - to December 2020, these respective ETFs have yielded almost identical performance numbers. This makes sense, as they are tracking similar markets, but not exact.
Let's assume you had $1,000,000 invested in $ITOT (the red line on the chart) right before the stock market tanked in March of 2020. Once your million bucks is down 20%, you decide to do some tax-loss harvesting and lock in a capital loss of $200,000 ($1mm x 20%). Once we've put that loss on the books, we can't simply turn around and immediately purchase back your $ITOT, as this would violate the wash-sale rules. So – we have a decision to make. Do we wait 30 days for the wash-sale period to elapse? This isn't advantageous as we could miss out on a market rebound. Instead, we could elect to purchase another ETF as a replacement for $ITOT as long as it is not 'substantially identical.' Fortunately, for this example, $VTI would serve as a spectacular replacement as it mirrors the $ITOT performance exceptionally well and doesn't violate the wash-sale rules. This is because each ETF seeks to track a different broad-based Index. $ITOT tracks the S&P Total Market Index, while $VTI tracks the performance of the CRSP US Total Market Index. Thus, we can take our capital loss of $200,000 and not concede much opportunity cost by not 'being in the game' and remain well-positioned and ready to participate in a potential bounceback.
What are the raw numbers in the scenario depicted above?
January, 2020: $1,000,000 account value, invested in $ITOT.
March, 2020: $800,000 account value + $200,000 in realized capital losses after selling $ITOT and immediately purchasing $VTI as replacement.
Tax-time for 2020: You use $3,000 of losses to offset ordinary income when filing your taxes for 2020. Let's assume your top tax rate is 40% between state, federal, and local taxes. This would save you $1,200 in taxes (3,000 x 40%). Your remaining $197,000 in capital losses will be carried forward to be used to offset ordinary income or capital gains in the future are now free of tax up to $197,000.
January, 2021: $1,200,00 account value, invested in $VTI
Takeaway: Get tax-write off without compromising returns? Sign me up. This is what we call in the biz "tax-alpha." Now, an astute nay-sayer might argue that all we have done is kick the can down the road by realizing a capital loss for a tax benefit today, only to have an unrealized capital gain tax liability tomorrow. While this is true, the adage of a bird in the hand being worth two in the bush certainly applies to tax-loss harvesting. $3,000 of write-offs against ordinary income each year are at a higher rate than you would otherwise pay on long-term capital gains. Plus, you may never realize those future gains as your beneficiaries would receive a step-up in basis. Pending tax legislation proposals may change this, but that is a conversation for another day.
Long-term tax-alpha expectations.
The example above is extreme in two regards. It assumes you have your entire portfolio invested in one ETF and showed impeccable timing by taking your capital loss near the market bottom. More realistically, let's imagine you had a well-diversified portfolio with eggs in many different baskets, each not 100% correlated to the next. You would want a replacement ETF identified for each part of the market (i.e., large-cap growth, large-cap value, long-term bonds, short-term bonds, etc.). This would enable you to realize losses on each part of the market individually rather than the market as a whole. Even further optimizing the tax efficiency of your overall portfolio.
As you might imagine, quite a few academic studies have been published with dense research on this strategy (CFA Institute). This study evaluated the S&P 500 from July 1926 - to June 2018 and found the gross long-term expected annual tax-alpha (assuming 35% for short-term gains & 15% for long-term gains) was 1.08%. After considering wash-sale rules and transition cost(s), the average alpha was 0.69% per year. Or, to say it another way, someone who bought and held the same portfolio but is not engaged in tax-loss harvesting can expect after-tax underperformance of roughly 0.70% compared to someone who takes advantage of such a strategy. The reality is that these benefits will be 'lumpy,' meaning, from year to year, the benefits could be higher or lower depending on market conditions.
$1,000,000 invested at 8% for 30 years balloons to $10,062,657
$1,000,000 invested at 7.31% (0.69% less tax-alpha) for 30 years only grows to $8,302,442, or ($1,760,215 less).
Why can’t I do this with individual stocks?
If you sell your stock, you can't purchase it back for 30 days because it would violate the wash-sale rule. Buying the same security isn't just 'substantially identical'; it is precisely identical! For more on how we view individual stock picking, check out this other blog post.
Why this could become even more impactful?
Two of the many tax proposals currently on the table from the Biden administration seek creative ways to generate additional tax revenue. Potentially doing away with the step-up in basis rule (when someone passes away, they can leave the stock to their heirs and not have to realize any taxable capital gains) and for household income's over $1,000,000 potentially having long-term capital gains taxed at the exact top rate as ordinary income of 43% instead of the current 23.8% top rate for long-term capital gains. Whether or not these proposals make their way to approved tax law, the reality is that taxes probably will trend higher going forward.
Bottom line: the long-term axiomatic results of tax-loss harvesting are undeniable.
When someone tells me I should be happy because I lost less than the market, it reminds me of what the grocery cashier says when I buy groceries: 'Because you're a member of our shoppers' club, you just saved $4.25.' No, I didn't. I just spent $87. However, not giving up much, if anything (performance), to get something potentially greater than what you gave up (tax benefits) is a smart choice. Any taxable account that does not take advantage of this strategy abhors logic and reason.
Remember, you've got to deal with the rain to get the rainbow. In both markets and in life, if there are no problems, then there is no progress. So when crises and disasters strike, don't waste them. Tax-loss harvesting is a strategy that can make market turbulence slightly more palatable, and in a way, possibly turn lemons into lemonade.
NOT INTENDED AS TAX OR INVESTMENT ADVICE. FOR A FULL LIST OF DISCLOSURES CLICK HERE.
“The obstacle in the path becomes the path. Never forget, within every obstacle is an opportunity to improve our condition.”
Sources
1 - “An Empirical Evaluation of Tax-Loss-Harvesting Alpha” by S.E. Chaudhuri, T.C. Burnham, and A.W. Lo, published in the Third Quarter 2020 Financial Analysts Journal.
