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The Bear Market Playbook: Tax Loss Harvesting

Updated: Mar 15



Tax Loss Harvesting Video Transcript

Welcome back to the video series called The Bear Market Playbook. And in this video, we’re going to talk about something called Tax Loss Harvesting. Let’s get into it.

Tax loss harvesting–what on earth does that possibly mean? In our tax code, there’s a very interesting provision for people that are investing in individual or joint accounts. We typically (within the industry) will often refer to these as brokerage accounts instead of an IRA or a qualified retirement plan.

These are the types of accounts that are going to have tax impacts when you transact within the account. So, if you are getting dividends and interest, those dividends and interest are often reported on your annual 1099 and are taxable to you. If you are buying and selling, you’re typically seeing capital gains capital losses within these accounts. And so, tax loss harvesting is a strategy that you can consider when the markets are doing volatile things like they are right now.

For example, when we see a decline in the market, the first thing that happens with most of us is we really don’t like that. We are conditioned to crave certainty. And when markets decline, that makes us feel anxious, nervous and fearful.

Our human tendency is to want to do something. However, most investing professionals would agree that good investor behavior requires us to ride through downturns so that we can continue to achieve long term, positive growth in our accounts.

But this just doesn’t work, Michael. I want to do something right now when pain is at an all-time high and I’m uncomfortable. Well, tax loss harvesting is one idea that you can consider if you are an investor with a brokerage account or an individual or joint account and account that has taxable implications.

Consider Tax Loss Harvesting

How does it work? What tax loss harvesting does is it allows you to sell positions that have declined in value and book the loss for tax purposes.

Now, you may have multiple uses for booking a tax loss. If you sell a position that has declined in value, you create what’s called a Realized Loss. That realized loss may be a short-term capital loss or a long-term capital loss. This distinction is important.

Short-term losses can offset short-term capital gains. Short-term capital gains hit your income statement as ordinary income or hit your tax returns each year as ordinary income. So, short term losses can offset or help offset Short-Term Capital Gains.

Long-term losses, however, can offset long-term capital gains. Now, it’s important that we understand there is a distinction with how short-term capital gains are taxed and how long-term capital gains are taxed. Don’t worry, we won’t go too deep into the tax code.

But traditionally, we like to match these up where short-term losses are used to offset short-term gains. Long-term losses are used to offset long-term gains. You can use short-term losses to offset long-term gains, but that is probably the least favorable use of those losses. So be careful and know what you’re doing.

As always, I should insert here, this is a great thing to talk about with a qualified financial advisor or a competent qualified tax professional. Taxes are a big deal of the investing game. We want to make sure you’re getting quality advice that is tailored to your situation.

Mind the Wash Sale Rule

All right let’s keep going. We’ve got some losses that we want to book. And so, we can transact and sell those positions and create a loss on paper or realized capital loss. Then we can do one of a few things.

We can maintain those positions in cash, wait for 31 days, and repurchase those same positions. This would effectively reset our tax basis in those positions. The reason we want to wait 31 days, if we’re going to buy those exact positions again, is something called the Wash Sale Rule.

The wash sale rule will essentially disallow a loss if we repurchase what’s called a “substantially identical” security within 30 days. So, for example, if you have shares of XYZ fund and you sell shares of XYZ fund to book the loss; then you repurchase shares of XYZ fund in 15 days, well, you’ve transacted again with a substantially identical security during that 30-day period.

That tax loss will likely be disallowed. What you would want to do instead is to hang on for 31 days after the 30-day period. On day 31, you can go back in and buy shares of XYZ fund.

Well, Michael, I don’t want to sit out. What if the market rebounds while I’m sitting on the sidelines?

That’s a great point. You can in fact buy something called a “similar security.” The language here is very nuanced, as is our tax code. However, what you cannot do is buy something that’s considered substantially identical, but you can buy a similar security.

So, if you sell shares of XYZ fund, you can’t go repurchase XYZ fund for 31 days, but you can buy shares of ABC fund that may be a similar security (but not considered substantially identical).

Match Losses With Gains

The next thing you can do if you have booked some losses, you can look at positions in your portfolio that have unrealized gains and potentially create some realized gains. You can use your losses to offset those gains in the same tax year. So, let’s say that we’ve sold shares of XYZ fund and we’ve booked a $5,000 long-term capital loss on that fund. Long-term loss means we’ve held it for over a year.

We’ve got a long term capital loss, and we’ve got now $5,000 in our loss bank. We can look over and say, you know what? I have shares also of ABC fund, ABC fund has $5,000 in long-term capital gain. If that gain is unrealized, you can then sell shares of ABC fund to book that $5,000 long term capital gain. You’ll have a $5,000 long term capital loss to offset the $5,000 long term capital gain effectively making your tax liability on those transactions zero.

So, this is one way that you can match up your losses and gains and whittle down that taxable income as it comes down to the end of the tax year.

Tax Loss Harvesting and Looking to the Future

The last thing you can do is you could book your losses, hang onto your winners, and plan to use those losses in a future tax year. This is called a carryforward on your capital losses. Thus, you can carryforward these losses.

When you try to do this, if you have more than $3,000 in losses that you’re carrying forward, $3,000 of that realized loss in this tax year will likely be used to offset $3,000 of income. So again, the example I will use is XYZ fund. We’ve sold it we have a $5,000 long-term capital loss, but we decide that we do not want to sell any positions to realize a capital gain.

That $5,000 loss will effectively flow through to our 1040. We can use $3,000 of the $5,000 loss against income. Then, we will have $2,000 that will carry forward into the next tax year.

These are a few ways that you can look at how to use tax loss harvesting. This is a very neat strategy for investors to use, especially in times where the market has been volatile. We often will see investors that have positions that they cannot liquidate in a given tax year because the tax penalty or the tax hit will be too great.

However, when markets decline, especially in bear markets where many assets tend to decline at the same time, investors are given an opportunity to either get out of these positions that are no longer desirable. And, they can minimize the tax impact. Or it’s possible that they can then sell these positions, book the tax loss, and reposition those assets into something else that they would desire to hold for a long-term investment.

Tax loss harvesting is a neat strategy. It can be used to enhance your overall tax positions in your portfolio. It can be used to give you a greater opportunity for tax favorability in the future.

But as always, I would encourage you to work with a qualified financial advisor or with a qualified tax professional to help you do this. The last thing we want to do is to be proactive when it comes to taxes yet not understand the impacts, which makes us actually end up with some surprises that get us on Tax Day.

Hopefully you found this information to be useful. Again, the bear market playbook we’re continuing to come up with ideas that you can use right now to continue to advance your portfolio and your long-term financial plans. Thanks for watching.

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