Loss Harvesting: Why & How We Do It

By {{_embedded.author.0.name}} on June 1, 2022

 By Frank Censullo, MSFP 

Director, Family Wealth & Estate Planning 

 In you’ve recently received a number of notices from your custodian (Schwab, Fidelity, and the like) about trading activity in your accounts, you might be wondering why. Rest assured, your Lexington Wealth Management advisors are not needlessly churning your accounts. Between the war in Ukraine and and the likelihood of additional Federal Reserve rate hikes to combat inflation, both stocks and bonds have struggled year-to-date. Your advisors are simply responding by taking advantage of the resulting portfolio losses. 

Many people – and certainly most investors – hate to lose. The Internal Revenue Code offers a bit of consolation, however, to investors who’ve seen the value of their investments decline. By selling those investments and “realizing” the losses – a strategy commonly referred to as tax loss harvesting – investors can lower their tax bills, and that’s what LWM advisors are currently doing for their clients. It might seem odd to associate tax losses with the idea of harvesting – an activity one hopes will yield a bounty – but it serves to underscore the value of the losses. 

 Gains are taxed when realized, but the tax benefit of losses can be deferred until needed.

Capital gains – your profits – are taxed in the year they are realized. So if you sell an investment that has appreciated in value, the tax consequence follows shortly thereafter. Realized capital losses, on the other hand, can either be used immediately – to offset capital gains dollar-for-dollar or, if losses exceed gains, up to $3,000 per year of ordinary income – or they can be carried forward until needed in subsequent years. They don’t expire until the death of the taxpayer. 

Seasoned investors recall just how steep the losses were back in 2008 and early 2009 (or again in March of 2020). Throughout this period, whenever an investment declined in value, we sold it and replaced it with something similar. If the replacement investment declined in value, too, we sold it as well, and either replaced it with the original (if we’d been out of it for at least 31 days) or yet another similar investment. 

One family we work with accumulated so many losses (to their credit, they stayed fully invested and have more than recouped those losses) that when they subsequently sold their vacation home on the Cape for significantly more than they’d paid for it, they incurred absolutely no federal tax cost. We were able to preserve the losses generated by the investment portfolio and, several years later, use them to offset the gain – a gain of more than $1 million! – from the sale of the home. 

Please note: losses generated in a tax-advantaged account – like an IRA or 401(k) – cannot be used to offset taxable gains. Only losses that occur in taxable accounts are eligible. 

At Lexington Wealth Management, we actively tax-manage our clients’ portfolios, and loss harvesting is just one of several tools available to us. In short, we utilize the almost inevitable losses to make sure you keep more of your hard earned money when you realize gains. 

How Do We Do It?

The basic mechanics are relatively simple. When an investment has declined in value, we sell it at a loss. The Internal Revenue Service’s Wash-Sale rule dictates if we immediately repurchase that investment or a substantially identical investment, the loss is disallowed. We have to wait at least 31 days to buy it back. In order to avoid being “out of the market” at a time when that investment might appreciate in value, we typically buy a somewhat similar investment. Remember: just because an investment declines in value doesn’t mean we don’t want to continue to own it. If it was good enough to own when the price was higher, it might be an even better value now, and purchasing a similar investment ensures your overall asset allocation remains intact. 

Just because an investment declines in value doesn’t mean we don’t want to own it. 

But what if the investment we sold suddenly appreciates in value while the replacement languishes or even declines? That could certainly happen. Similar investments – even the stocks of two companies operating in the same industry – can behave very differently over short periods of time. Performance results are not guaranteed, but what is certain, is the tax benefit that comes from harvesting the loss. 

How Often Do We Do It? 

It varies, but some advisors will sell any investment that declines by $1,000 or more, while others might not pull the trigger unless a loss exceeds $5,000 or $10,000. Losses tend to appear more frequently in newly created portfolios because there haven’t yet been years of built-in gains to absorb them. Harvesting is often done in conjunction with portfolio rebalancing or might be done just prior to year-end to make sure the losses are usable when the tax return is filed. If a client has already realized gains in a given calendar year, we’re going to be aggressive about harvesting any available losses. Fortunately, trading costs for Lexington Wealth Management clients are minimal. We shun mutual funds that impose sales loads and watch out for those with short-term redemption fees. These might need to be held for 90 days or more in order to avoid paying a fee of 1% or 2% and may not be appropriate for a harvesting strategy. 

What Happened to “Buy Low, Sell High?”

It might appear we are violating this investing maxim, but while we’re locking in a tax loss, we’re not locking in a permanent loss of capital. By replacing the losing investment with a similar investment, we position ourselves to participate in the upside potential. If it happens during the next 30 days, we should capture at least some of it, and if it takes longer than that, we’ll have the opportunity to switch back to the original. 

So What’s the Catch?

By selling an investment at a loss and replacing it with a similar investment that, ultimately, appreciates in value, we’re building in additional unrealized gain that wouldn’t have been there if we’d, instead, simply held onto the original investment while it dipped and rose back up in value. If the replacement investment is eventually sold, the larger gain will generate a higher tax cost. Some advisors might argue, therefore, that all harvesting really accomplishes is tax deferral. 

That deferral can be useful, though, in freeing-up capital for other purposes or making additional investments. What’s more, if an investment is held until death, its cost basis is (at least under current tax law) “stepped up” to the value on the date of death, effectively erasing any as yet unrealized gain. Estate tax rules require “step downs” as well (if someone dies owning property that has declined in value, the cost basis is lowered to the date-of-death value), so we harvest losses during life to avoid losing them at death. Appreciated securities can also be given to charity in lieu of cash. In any case, an investor won’t simply have deferred a tax, he or she will have avoided it entirely. In our view, that makes deferring tax well worth the effort. Please give us a call if you’d like to discuss further.

^{Disclosures: Lexington Wealth Management is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates. Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.}