Harvesting losses seems like an automatic thing to do in a year where most asset classes decline in value. Like anything else, though, it makes sense for some, but it is not a great idea for others. Even for those for whom it does make sense, the advantages are limited and only begin to benefit you once you have gains to offset the losses. For some people, surprisingly, capturing GAINS is a good strategy!
First, a quick review:
Assume you purchase a stock, mutual fund, or ETF for $100, and its value declines to $80. If you sell the investment, you “capture” a loss of $20. That loss may offset capital gains whenever they occur, and if you do not have any gains in the same year, then the loss can be carried forward forever (it does disappear at one’s death, which means some planning may be necessary if you are ill). You may also use the loss by deducting up to $3,000 from ordinary income as long[1] as it exists.
Once you sell the investment, you may want to immediately repurchase it since you probably invested initially in that asset because you felt good about its prospects for gain. Unfortunately, the IRS has something to say about that. While they certainly do not care if you repurchase it, they do care if you sell something at a loss and immediately repurchase it while claiming it. Therefore something called the “Wash Sale Rule” creates guardrails in time preventing you from doing that:
The wash-sale rule prohibits selling an investment for a loss and replacing it with the same or a “substantially identical” investment 30 days before or after the sale. If you do have a wash sale, the IRS will not allow you to write off the investment loss, which could make your taxes for the year higher than you hoped.
This rule causes people to consider purchasing an investment similar to the one sold, enabling you to remain invested after the sale.
Long-term losses are those realized from the sale of an investment held longer than 365 days, and short-term losses are for sales before they mature into long-term losses. Short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain.
The Advantage:
Offsetting future gains and having the ability to offset 3,000 of ordinary income in years where the losses cannot be used sounds like a great idea. Unfortunately, the true benefit does not begin to accrue until you save tax by offsetting gains with the losses. Additionally, you turned an asset with a cost basis of $100 into an investment with a cost basis of $80. In the future, you will probably sell that asset at $100 or above, meaning you did not permanently eliminate the potential tax; you only deferred it.
How does the benefit accrue? Assuming you captured the loss of $20 and in some year or the same year were able to offset (we are ignoring the 3,000 offsets against ordinary income here for this example) $20 of gain, you are probably saving $3 in tax ($20 times an assumed capital gains tax rate of 15%). Eventually, you will have to sell the asset, which now has a lower cost basis as mentioned above; you are only “borrowing” that $3 in tax liability savings from the future. Investing that $3 at an assumed rate of return of 8%, the gain on the deferral is $.24 per year. Based on this calculation, you can see that the advantage is not as significant as one may think.
There may be times when capturing this loss can provide far more significant benefits, but it may not make sense in every case.
If you believe you may be in a lower capital gains bracket in the future (the rates are 0%, 15%, and 20%), then capturing the loss when you are in the higher bracket may lead to the deferral of all or part of the tax liability forever. If you are in the 0% tax bracket now, capturing losses may not make sense, especially if you anticipate being in a higher tax bracket. It also makes no sense to capture losses in an IRA, traditional or Roth. There is also a risk that the replacement investment may not “track” or perform as well as the one you sold; therefore, you may decide to sell the replacement once the 30-day wash rule expires. Unfortunately, if the new investment increased in value, you are now capturing a short-term gain offsetting the original loss you captured. It also may not make sense to capture a loss if you are planning to liquidate the asset soon since replacing the asset and then selling the replacement soon means you gained nothing from capturing the loss if the asset recovers in price.
Surprisingly sometimes it may make sense to capture gains! If you are in a 0% capital gains tax bracket selling an appreciated asset enables you to capture the growth with no tax. Because the 30-day wash rule does not apply, if you are not trying to claim a loss, you can immediately repurchase the asset you sold, resulting in ownership of the same asset but with a higher cost basis! So, for example, if you had the investment you purchased for $100, it appreciates to $120, you can sell it, capture the $20 gain and almost immediately repurchase it for $120 with your new cost basis being $120. This strategy makes even more sense if you anticipate being in a higher tax bracket in the future. As we write this, there is a 0% capital gains tax rate for a single person if your taxable income is less than $41,675; for a married couple filing jointly, the threshold is $83,350. If you are receiving other income, for example, Social Security, we suggest proceeding carefully; while you may be in a 0% capital gains bracket, the gain may force some of your Social Security to become taxable, moving you into a higher marginal bracket for ordinary income taxation.
In conclusion, we suggest carefully considering if capturing losses benefits you in the long run, and as you can see, there are many things to consider.
We discuss this at length in our video:
[1] Sadly that figure, $3,000, has been the same since 1977! If that is inflated from 1977 to 2022, the amount would be $14,667.
