Stocks, and even bonds this year have given us lackluster performance, but there are still steps we can take to see the silver lining and bring a positive outcome out of a negative experience. When investments in a taxable account such as an individual or brokerage account perform negatively, you can sell them at a loss and harvest the difference. This is called tax-loss harvesting. It allows you to sell the stock and harvest the loss.
The IRS has a rule called the “wash sale rule” which disallows you from being able to sell the security for a loss if you buy an identical or “substantially identical” security within 30 days of the sale. So in other words, if you sell Ford stock at a loss (and it was down 12% in one day last week- oof), and then buy Chevy stock a day later, the IRS will disallow your loss harvesting because it is a substantially identical security.
A good strategy then would be to sell shares at a loss that you can use to offset up to $3,000 of your ordinary income taxes or an unlimited amount of your capital gains taxes and then invest in a better security. This other investment may be substantially identical as long as you wait the 30 days, or you could buy a different stock or actively managed fund the very next day.
It’s important to remember that tax loss harvesting can only be accomplished in a taxable account such as a brokerage account or with investment real estate. It can’t be used in retirement accounts because they are either tax-deferred or tax-free already. It cannot be used with personal property such as vehicles or furniture.
Tax loss harvesting should be used as part of an overall rebalancing strategy. For instance, if your energy stocks have performed very well and your technology stocks have underperformed, you will want to rebalance by buying more technology stocks and selling some of your gains from the energy stocks—this may lead to superior returns in the future as the beaten-up tech stocks revert to the mean and perform positively whilst the energy stocks are less positive. Therefore, you are buying low and selling high the different asset classes within your portfolio. You can use the losses from the tech stocks to offset the gains from the energy stocks so that you don’t owe any big tax bills.
The current real estate and stock market climate of 2022 brings with it an interesting opportunity for investors wishing to cash out on some of their real estate investments. For example, if you sell a rental property, you will owe tax on the long-term capital gains. However, you can offset this tax by selling a losing investment in your brokerage account to offset the tax. If you are unable to counteract the gain with a loss, you could execute what is called a 1031 exchange by buying another rental property to defer the capital gains taxes or you could invest the proceeds in what is called a Delaware Statutory Trust.
In addition to offsetting capital gains taxes, selling a security for a loss can also offset up to $3,000 of ordinary income taxes every year. Above that amount, your loss can also be carried forward an unlimited amount of years. For example, if you have $30,000 of loss in one year, you can use that against your ordinary income taxes in the amount of $3,000/year for the next 10 years.
A good rebalancing and tax-loss harvesting strategy is an important key to long-term wealth building and may bring superior results to your portfolio.
When Daniel is not giving financial advice or managing investments, he enjoys renovating properties, real estate investing, drinking coffee, hanging out with friends, spending weekend trips in his camper van, and exploring the outdoors on a hiking or biking trail in his hometown of Roanoke, VA and beyond.