As the calendar year comes to a close, now is an excellent time for investors to harvest losses inside their taxable investment accounts. Tax Loss Harvesting is the practice of selling investments at a loss (also known as ‘realizing’ the loss). When done correctly, this strategy is used to offset capital gains (and up to $3,000 of ordinary income), reducing an investor’s overall tax liability.

Tax Loss Harvesting is both an investment and tax strategy we use for our clients to help minimize their taxable liability, whether it is a capital gains tax liability or an ordinary income tax liability.

One important note is that tax loss harvesting trades can only be performed in taxable accounts. Because IRA’s and 401(k)’s are tax-deferred, there are no capital gains to offset by realizing capital losses. Individual and joint brokerage accounts are considered taxable accounts, and all tax loss harvesting should be done inside these accounts. 

In a summary, the steps to successfully harvest losses is below:

1. Review your portfolio’s investments
2. Find an investment security similar to the one(s) underperforming
3. Sell (realize) the investment security & purchase the similar investment security
4. Hold the new investment security for 31 days
5. After 31 days, consider repurchasing the original investment

The steps above are instructions for solo investors interested in harvesting tax losses on their own. The below section gives the explanation for each step.

Before realizing any losses, it’s important to understand which securities an investor can use to harvest losses. Mutual funds, exchange-traded funds (ETF’s), and individual stocks can all be used to harvest losses. As long as the position is sitting at a loss, it can be used in tax loss harvesting.

Example: Henry’s Portfolio

For example, Henry is an investor who is focused on maintaining an exposure to the S&P 500 index. This year, he looks at his 20 shares of SPY (an S&P 500 ETF) and sees they are down about $1,000. Henry recognizes he can sell these shares of SPY to offset some of his other capital gains.

Investors who maintain set exposures to different market sectors can retain their portfolio’s exposure by purchasing an investment similar to the one they are selling. If an investor were realizing capital losses on an index fund that tracks, say, emerging markets, they can find another index fund tracking emerging markets to replace the original security.

Continued: Henry’s Portfolio

Because Henry wants to maintain his exposure to the S&P 500, he looks for other investments that have similar characteristics to SPY. After some Googling, he finds VOO (Vanguard’s S&P 500 ETF) and deems it a suitable temporary replacement for SPY.

Once the investor knows which securities they are selling and they have suitable replacements for those securities (to retain market exposure), they can execute the transaction. In this step, the investor is selling each security at a loss and purchasing the similar investment securities using the proceeds.

Continued: Henry’s Portfolio

Henry logs into his investment account and makes two trades: sells 20 shares of SPY, and he purchases 20 shares of VOO. Here, he realizes the capital losses on his SPY position and maintains his exposure to the S&P 500 index by purchasing VOO.

When an investor sells the original security, they cannot repurchase that same security for 31 days, otherwise the transaction will be considered a “wash sale” and losses will not be realized on the position. By purchasing a security similar to the one they are selling, an investor avoids a wash sale and maintains their original market exposure.

Continued: Henry’s Portfolio

For one whole month, Henry does nothing with the VOO shares inside his investment account.

After 31 days, an investor can repurchase their original security if they like the original investment more than their new investment.

During tax season, the investor’s custodian will likely produce a consolidated 1099 form for them. On the 1099, an investor can see the total amount of losses harvested, the total amount of realized capital gains, and the net capital gains (or losses) that will affect their overall tax liability.

Continued: Henry’s Portfolio

When day 31 hits, Henry considers switching back to SPY. However, he recognizes that the expense ratio on VOO (0.03%) is lower than the expense ratio on SPY (0.09%). He likes the lower expense ratio because it reduces the drag on his portfolio. He decides to keep his VOO investment for the long term.

Henry is pleased when he look at his 1099 and sees that his capital gains tax was reduced by $1,000 from his SPY strategy.

At Chicago Partners, we evaluate opportunities and manage the process for tax loss harvesting throughout the year, including security review, trading, and repurchasing on behalf of our clients. While year-round tax-loss-harvesting is part of the services we offer clients, any investor can successfully tax loss harvest using the steps above. Contact us today to learn more or to start your portfolio audit!