Tax Loss Harvesting

Tax loss harvesting refers to making up for the expected losses on one investment with the realized profits on other investments to offset the net profit, which is finally the taxable income. Tackling the losses using the huge gains lowers the net income for the entity, thereby reducing its tax liability.

Tax loss harvesting allows investors to play smart and protect their profits to a significant extent. They sell their failing assets and invest the funds accumulated in purchasing the profitable ones that would help them earn profits in the later stage.

• Tax loss harvesting is a popular strategy wherein the loss-making securities are sold to reduce the tax liabilities arising from gains made in the other securities.
• The basic rationale behind this is to offset capital gains against capital losses by selling those investments with unrealized losses, thereby reducing the tax liability.
• It is a smart way to improve investment efficiency and after-tax adjusted returns.
• Short-term and long-term are the two types of tax loss harvesting observed in the United States.

Tax loss harvesting allows investors to sell their assets that are likely to fail and use that amount to purchase those stocks that appear profitable in the long run. This gives investors a chance to show their net profit as the difference between the amount reaped as gain and the amount incurred as loss and, therefore, register the differential amount as their taxable income. In short, this method of harvesting tax losses lets investors offset their taxes.

It is a tax-reducing strategy that is not based on speculation. Therefore, a smart investor can use it effectively to compound its tax-adjusted return. It also helps an investment portfolio generate investment returns and compound them by enriching them with tax savings. Investors use this strategy to offset future losses, thereby reducing future gains and helping in future tax savings.

This tax-saving method works effectively for investors who hold securities in their taxable accounts. They can utilize these losses incurred to save on taxes and turn the negative results into positive ones. Above all, tax loss harvesting in crypto is gaining momentum, given the willingness of investors to invest in these currencies. Here, investors sell assets at a loss and offset capital gains from various investment portfolios.

Tax loss harvesting rules are necessary to be aware of as it does not allow investors the liberty to buy or sell stocks anytime based on the realized losses and profits. An investor cannot sell a stock, realizing a loss to reduce the tax liabilities, and then buy the same or similar stocks later. This restriction put on the intentions of investors is termed wash sale.

The wash sale rule applies when investors sell securities at losses and buy or acquire an options contract to purchase identical securities within 30 days before or after the sale. However, this tax loss harvesting limit does not restrict investors from buying stocks/securities in the same industry.

Let us consider the following tax loss harvesting example to see how it is calculated:

Frank holds a portfolio comprising five stocks. During the year, the performance of different stocks in his portfolio is as follows:

Frank had made a realized gain of $45000 during the year on shares he bought and sold.

To make it simple, let’s assume all the gains made are short-term, and the applicable tax rate is 20%.

Tax on Short Term Capital Gain= $45000*20% =$9000.

Let’s understand how tax-loss harvesting results in lower tax outflow for Frank. Suppose Frank sold off his holding in Boeing and Chegg, resulting in a net realized gain of $28000 ($45000-$17000). He then utilized the profits to buy shares of other companies from a similar sector to ensure the portfolio risk levels remained the same.

Doing so reduces the tax liability to $5600 ($28000*20%). Thus, it creates value by reducing Frank’s tax outflow by $3600.

The tax loss harvesting technique helps defer tax liability, indirectly increasing the tax-adjusted returns for investors. The returns maximize if they do not intend to liquidate their portfolio and continue to hold it until retirement, as their taxable income is likely to reach the minimum post-retirement. In addition, it is useful for those who frequently make short-term capital gains and attract higher tax rates. Using this strategy, their tax outflow reduces substantially.

Besides reducing the tax burden for the investors, this strategy also lets them keep their portfolios balanced by buying, selling, and rebuying stocks from time to time.

Gains subject to tax loss harvesting are usually classified into two categories. However, the criteria differ from one jurisdiction to another. The U.S. jurisdiction classifies it as:

• Short-Term Capital Gain/Loss: Any purchase or sale in a security held for less than a year, resulting in gain/loss, is a short-term capital gain/loss. Here, the normal income tax rate applies, i.e., 10-37% based on the income group one belongs to.
• Long-Term Capital Gain: Any purchase or sale in security that investors hold for more than a year, resulting in gain/loss, falls under long-term capital gain/loss. In this case, the income tax rate can be as low as 0% but will not exceed 20%.

The investors, however, can use only long-term capital gains to set off long-term capital gains. It means they cannot use a short-term capital gain to offset long-term capital loss or long-term capital gain to offset the short-term capital loss.

This article is a guide to what is Tax Loss Harvesting. Here, we explain how it works along with its rules, an example, benefits, and short- & long-term losses. You can learn more about accounting from the following articles –

• Marginal Tax Rate
• Earnings Before Taxes
• Tax Loss Carry Forward
• Capital Loss Carryover