Executive Summary
Capital loss harvesting has long been a staple of investment tax strategy - so much that the Internal Revenue Code has special "wash sale" rules to ensure that the technique is not overly abused. Fortunately, though, the wash sale rules can be navigated effectively, allowing taxpayers some means to take advantage of available tax losses.
However, while tax loss harvesting remains a viable strategy, it is often greatly overvalued, as the true benefit is not the tax savings from harvesting a loss but merely the benefit of deferring those gains. In the meantime, the strategy has a non-trivial exposure to several risks, including the potential for the alternative investment held during the 30-day wash rule period underperforming the original investment, the possibility of negative tax arbitrage if the investment rebounds in the near term, and the danger that harvesting losses too effectively over time will drive the client's future capital gains into a higher tax bracket! In addition, the fact remains that capital loss harvesting produces no benefits for clients who are eligible for 0% capital gains tax rates, and in fact potentially harms them; in such scenarios, clients should actually be harvesting gains, not losses!
Ultimately, this doesn't mean that harvesting capital losses is a bad strategy, but it is a strategy where the risks must be carefully considered, as they can easily outweigh the relatively modest benefits!
Tax Deferral, Not Tax Savings
One of the fundamental points of confusion about capital loss harvesting is that it doesn't permanently save taxes, it merely saves them temporarily - in essence, it just defers them. The reason is that when capital losses are harvested, the new investment position after loss harvesting has a new, lower cost basis - which means if the investment is ever intended to be sold or consumed during life, someday the taxes will still be due.
For example, assume an investment was purchased for $100,000, but is now worth only $90,000 due to a significant market decline. The investor harvests the $10,000 capital loss, which generates a $10,000 loss deduction resulting in $1,500 of current tax savings at a 15% tax rate. However, after harvesting the loss, the investment only has a cost basis of $90,000, which means if the investment ever recovers to $100,000 again, there will be a $10,000 gain, resulting in a $1,500 tax liability at the same 15% tax rate. Thus, in the end the $1,500 tax savings now is offset by a $1,500 tax increase in the future, and the net result is $0 of tax savings (which makes sense, since the investment started at $100,000 and ended at $100,000)!
Of course, the caveat is that the tax deduction occurs now, and the tax liability for the recovery occurs in the future. Thus, the true value of harvesting the capital loss is the opportunity to invest the near-term tax savings for growth. For instance, if the $1,500 tax savings (which was 1.67% of the original investment, or $1,500 / $90,000) can be invested at an 8% growth rate, then the investor can earn a $120/year of economic value. However, relative to an investment that was worth $90,000, this true economic value of loss harvesting is a remarkably small benefit of only about 13 basis points (0.13%) per year! And of course, the benefits must be weighed against the potential costs to complete the transaction; with a $90,000 investment it might be appealing, but with a smaller investment position like one worth only $9,000 (and therefore an economic value of only $12/year of tax dollar) the raw trading cost to execute the sales and (re-)purchases may exceed the entire benefit!
In addition, there are also important indirect costs and risks to consider...
Tracking Error Risk During Wash Sale Period
One challenge to harvesting losses is that under the "wash sale" rules, the client who sells an investment for a loss must allocate the money elsewhere for 30 days to avoid having the loss disallowed. If a "substantially similar" investment under IRC Section 1091(a) is purchased during the interim time period, the loss cannot be claimed, and instead is added to the cost basis of the replacement investment (which means the loss is ultimately deferred to the future, although if the security is repurchased inside an IRA the loss may be forfeited permanently!). The wash sale rules can be avoided by investing in something else that is similar - but not "substantially" similar - or by simply keeping the money in cash or something else completely different.
Of course, if the goal is to remain invested, taking the money out of the market and into cash or a completely different investment is unappealing. In fact, owning anything that is materially different than the original investment may be unappealing - after all, if the investor wanted to actually own something different, the investment could have just been sold outright in the first place. The whole point of "loss harvesting" is to capture the loss without materially changing the investment!
As a result, investors try to buy something that is as similar as possible to the original investment, without running afoul of the rules. Historically, this was done by buying another stock in a similar industry - for instance, harvesting a loss in Ford and buying GM during the intervening time period, or harvesting a Merck loss and buying Pfizer instead. In today's world of pooled investment vehicles, the lines have blurred a bit, and it's less clear about what exactly constitutes an investment that is not "substantially similar" - selling a large-cap index and buying a small-cap index would almost certainly be fine, but it's less clear in the case of selling a large-cap index like the S&P 500 and buying a total market index instead, given that the returns of both will be dominated by the same set of (cap-weighted) stocks.
The reason why this matters is that if the investment results are too different - even just for a period of 30 days - there's a risk that the entire 13 basis points of economic value for harvesting the loss will be potentially lost by return differences as the temporary new investment fails to track the original investment effectively (not to mention merely any potential drag due to possible differences in expense ratio). Of course, the goal of many loss harvesting investors is to purchase an investment similar enough to reduce any exposure to significant tracking error. Yet the reality is that if the investments track too perfectly (for instance, mutual funds or ETFs that mimic the same underlying index), it runs afoul of the wash sale rules!
In other words, avoiding the "substantially similar" wash sale rules essentially requires the investor to be exposed to a material amount of tracking error! Of course, there's also a possibility that the replacement investment could outperform rather than underperform - not all "tracking error" is bad! - yet nonetheless the reality is that almost by definition, the investor can only harvest a loss if the replacement investment places the entire value of loss harvesting at risk to a comparable or greater amount of tracking error!
The Risk Of Negative Tax Arbitrage
In addition to the risk of tracking error overwhelming the economic value of harvesting a loss, a secondary challenge is the risk that the investment rises in value during the 30-day period, effectively converting a long-term capital loss into a short-term capital gain.
For instance, if an investment purchased 2 years ago for $100,000 has fallen to $90,000, and the $10,000 long-term capital loss is harvested, but during the interim period the investment rebounds to $98,000 and the client wants to switch back to the original investment, the rebound will trigger an $8,000 short-term capital gain. Fortunately, the loss can offset the gain if they fall in the same tax year, but notably the capital gain/loss ordering rules require long-term losses to offset long-term gains first. As a result, if the client already had $10,000 of other long-term capital gains, the loss harvesting transaction effectively converts a $10,000 long-term capital gain into an $8,000 short-term capital gain. If the client is subject to a 25% ordinary income tax rate (along with a 15% long-term capital gains tax rate), the client actually turned a $1,500 tax liability (15% of $10,000 long-term gain) into a $2,000 tax liability (25% on $8,000 of short-term gain)! This is essentially a form of negative tax arbitrage - the investments don't materially change, but the tax rate moves in the wrong direction! Of course, as with the tracking error scenario, it's possible that the investment won't change in value, or that it will go down even further and that there will be an additional short-term loss to harvest. Nonetheless, the scenario represents another form of risk to the loss harvesting transaction - and with volatile investments, a potentially material risk given how small the benefits of loss harvesting are in the first place! In addition, there's always the risk that within a year after the wash sale is completed, the investment will be sold after rising in value, triggering a(nother) short-term gain on the original investment that would have been long-term if the loss was never harvested in the first place!
An even greater form of negative tax arbitrage emerges from the fact that in today's tax environment, there are effectively four long-term capital gains tax brackets. As a result, if an investor systematically harvests $10,000 of losses from a portfolio every year - reducing cost basis by $10,000/year in the process - after a decade of the strategy a subsequent liquidation could trigger a whopping $100,000 capital gain in a single year (or much more when accounting for not just recovery back to the original purchase price, but real growth on top of that). If the loss harvesting occurs enough times over enough years, it creates the potential of such large capital gains in the future that the client ends out in a higher capital gains tax bracket down the road! Thus, if the capital losses are harvested at a 15% tax rate, but they create so much more gain in the future that eventually the recovery is taxed at 18.8% (with the new 3.8% Medicare surtax) or even at 23.8%, the client could destroy far more value by boosting the tax rate than was ever gained in benefit from the loss harvesting strategy itself! And the negative tax arbitrage is even worse if the losses are accidentally harvested for clients in the bottom two tax brackets - who are actually eligible for 0% long-term capital gains rates, and should actually be harvesting gains instead!
Of course, if investments are ultimately held until death, they receive a step-up in basis, which is a form of positive tax arbitrage (as the gains are effectively at 0% but the losses were harvested at some more favorable rate). Nonetheless, if the client ever intends to sell the investment to spend during life - and/or ever anticipates making an investment change - then the reality is that a step-up in basis is not really an option, but the risk of negative tax arbitrage remains a danger.
Ultimately, none of this means that capital loss harvesting doesn't have any value - there is still some benefit, and the larger the loss (or the higher the tax rate) the greater the value (although the recent proposal to require average cost accounting for all investments would partially limit the ability to harvest losses strategically). But the reality is that unless the tax rate is very high or the loss is very large, the benefit is actually quite limited, as it is based not on the amount of tax savings, but only on the economic value of deferring those taxes to the future! And in the meantime, the risks remain; in fact, some risks like exposure to tracking error are essentially a requirement to avoid the wash sale rule in the first place, and while larger losses create a greater harvesting benefit they also create a greater exposure to negative tax arbitrage and higher rates in the future! And that's before accounting for the raw transaction costs of loss harvesting in the first place, which may be fairly low in today's low-cost trading environment, but still represents an important threshold when considering how small of a loss is worth harvesting at all. In the end, all of this doesn't take loss harvesting off the table altogether... but it does mean the (limited) benefits must be weighed carefully against the costs and risks inherent in the strategy.
Since you’re making a qualitative statement, Michael, it’s hard to argue. That said, since we as advisors spend so much energy emphasizing how valuable tax-deferred investments are for clients, I’d disagree with the implication that this objective isn’t extremely valuable in and of itself.
The multiple cap gains tax rates can further increase the value of harvesting, as one could potentially massage the marginal cap gains tax rate through harvesting.
Finally and perhaps most importantly for elderly clients, by tax harvesting to defer cap gains you may end up with good ol’ tax avoidance, compliments of the step up in basis.
Tax harvesting is not a panacea to be sure, but it’s a valuable tool for planners who increasingly must justify the ~1% annual cost to clients!
Keep up the thought-provoking commentary.
Michael,
The whole point of this is that yes, tax-deferred investments really are NOT as valuable as we make them out to be, unless the returns are very high, or the costs are very low, or some combination of the two. At least with pre-tax retirement accounts, the benefit is amplified because the tax savings is on the principal (the deductible contribution) AND the growth/interest. With harvesting capital gains/losses, though, it’s just on the growth, which limits the benefit (ironically because the preferential capital gains tax rates reduce the value of tax deferral strategies).
Multiple capital gains tax rates can increase the value of harvesting IF the losses are strategically timed to coincide with big income years. But that’s about strategically timed loss harvesting, NOT systematic loss harvesting. It also means avoiding excess loss harvesting that creates carryforwards, because that eliminates the ability to time the loss (which might accidentally be used in a low-tax-rate year instead). After all, while harvesting a loss can help more in a high-tax-rate year, it can actually destroy wealth if it’s done in a low-tax-rate year (triggering higher tax rates in the future by resetting cost basis lower).
Similarly, we find tax loss harvesting must be done very cautiously with elderly clients, as many can have low-income and low-tax-rate years where harvesting losses is actually destructive – especially if they’re netted against 0% capital gains. Obviously, for ultra-high-income clients – senior or otherwise – the loss harvesting is more valuable, as the rates are higher, but that’s actually less about the age and more about the tax rate.
No disagreement that harvesting losses and holding the gains until death is a benefit, although in practice our primary focus is helping people maximize the money they can spend and live on while they’re alive. But certainly if you’re working with clients who know for a fact they have large amounts of money they will deliberately never touch, planning for step-up in basis (with loss harvesting and lots of other strategies) is highly appealing.
– Michael
I don’t understand: “if an investment purchased 2 years ago for $100,000 has fallen to $90,000, and the $10,000 long-term capital loss is harvested, but during the interim period the investment rebounds to $98,000 and the client wants to switch back to the original investment, the rebound will trigger an $8,000 short-term capital gain.”
If the loss is harvested, doesn’t that mean the investment now worth $90,000 was sold? What do you mean ‘switch back’? Has the investor repurchased (in 30 days) the same investment? Wouldnt the new purchase price be $98,000?
I have the same question about: “The investor harvests the $10,000 capital loss, which generates a $10,000 loss deduction resulting in $1,500 of current tax savings at a 15% tax rate. However, after harvesting the loss, the investment only has a cost basis of $90,000, which means if the investment ever recovers to $100,000 again, there will be a $10,000 gain, resulting in a $1,500 tax liability at the same 15% tax rate.”
Clearly I’m not a financial planner and am missing something…. Thanks.
Nancy,
The point here is that the investment worth $90,000 was sold, the investor bought “something else” for $90,000 while waiting the 30 days, and during the interim 30 days, the market (including the “something else”) jumps up in value to $98,000 (to pick an arbitrary rebound point). We saw this happen extensively to clients who insisted on harvesting in October of 2008, only to see a rebound by November which triggered a bunch of short-term capital gains when they switched back to the original investment.
In the second example, the point is just that if you harvest a loss on something that goes from $100k to $90k, and then sell it later when it recovers from $90k back to $100k, you still did nothing more than create a net wash. You got a $10k loss, and created a $10k gain. You could have just kept the thing you bought for $100k and sold it later for $100k for nearly the same result, because the timing (loss now, recovery gain later) actually just amounts to a tiny economic value (which is often overwhelming by the risk or even transaction costs of trying the whole endeavor in the first place).
– Michael
As usual, Michael, you have written a very thought-provoking article, this time, addressing various aspects of tax loss harvesting. I agree with your points, while also having a somewhat different take in some areas.
First, I have always told my (RIA) clients and (TRX) advisors that investment strategy should not be compromised for temporary tax savings. This would be a clear case of the “tax tail wagging the dog.” If there is not an alternative position or fund that is an acceptable holding for the long-term, loss harvesting should not be done. Further, losses should not be harvested when it is intended to move back to the original position after the 30 days. Why? Because this indicates that the alternative fund is viewed as inferior to the current fund. Should the new fund appreciate during the subsequent 30 days, the advisor is faced with either selling the fund at a gain – negating the loss harvesting – or keeping an inferior investment. Thus, my original statement: no loss harvesting unless the alternative is a good long-term hold.
I agree that tax loss harvesting is not appropriate when the zero capital gain rate applies. However, I am a fan of accumulating losses that can be carried forward to offset future gains. Loss harvesting on an ongoing basis can effectively produce ongoing benefits year-after-year, moving toward the “ultimate” tax avoidance – step-up at death. This type of strategy works similarly to accelerated depreciation. In theory, the piper must eventually be paid. In a thriving business, the piper might never be paid; ongoing accelerated depreciation and new asset purchases convert into more of a permanent tax savings than postponement.
Finally, I always get to the psychological benefit of loss harvesting: Clients hate to pay taxes. Writing a check now always feels worse than writing a check later.
With the exception of no acceptable alternative fund or zero capital gain rate, tax loss harvesting done opportunistically throughout the year can be extremely beneficial. And (shameless plug), rebalancing software like TRX can help make it happen!
Michael,
Great post! I tend to focus more on gains harvesting at year end for clients in the 0% gains bracket, but certainly do evaluate harvesting losses. The only time it seems to make a lot of sense is if the assets are truly for the next generation and the step-up in basis is worth the trouble.
Keep up the great work!
Michael,
Excellent article. Some of the negative effects can be minimized. One way trading can be utilized. Sell an investment for another and not switch back. Tax loss harvesting is an ideal time to go from one manager (for funds) to another that you may want to use. It is also an opportunity for rebalancing. In these cases the tracking error is irrelevant plus the trading costs reduced because you are killing two birds with one stone.
Lastly, agree no taxes may be saved, just deferred. However, if the capital gain taxes are deferred this could have a benefit if the client is close to retirement. It is also very helpful to have a -$3,000 capital gain figure locked in for your tax projection so it makes it is easier to do tax planning and perhaps take advantage of some tax planning strategies that may not be available if typical capital gain income needs to be added into the client’s AGI.
Thank you for your great newsletters!
Michael,
I think this is a good article about tax-loss harvesting, but there many other factors that should be taken into consideration. When used properly, tax-loss harvesting is a powerful tax management strategy that can add tremendous value to clients. You are right that tax-loss harvesting is not appropriate for investors subject to 0 percent capital gains, but are there any advisors out there who have clients subject to 0 percent capital gains and have a sizable taxable account worth employing such a strategy (since tax-loss harvesting doesn’t apply in tax-efficient accounts)? The wash sale rule is also an important factor, but most advisors use mutual funds versus individual stocks so they can avoid the wash-sale rules by simply selecting another highly correlated fund or simply rebalancing to another asset class within the client’s IPS. Tax-loss harvesting is yet another example of how advisors add value to their clients because advisors should coordinate with the client’s CPA during their annual planning meeting to ascertain – is the client expecting to sell an asset in the future that will trigger a capital gain; does the client already have a lot of tax-loss carry forwards, but now needs to offset some gains; does the client have a concentration in low cost basis stock that should be diversified; is the client young or old to assess step-up considerations; how much does the client donate each year and to which charities; and what is the client’s expected future earnings? These and other such questions should be discussed together with the client and their CPA each year to determine whether the advisor should tax-loss harvest or take gains off the table. The point I’m trying to make is that tax-loss harvesting should not be assessed in a vacuum; the advisor has to work with the client’s other advisors to see what else is going with the client’s overall financial picture before making investment decisions.
Michael,
Thank you for the clarification. I completely agree with you that such a strategy is not suitable for a retired person with a $2 million taxable portfolio. I didn’t realize your article was aimed at retirees. I think it’s the exception and not the norm for a non-retired person to have a multi-million investment portfolio (not retirement accounts) and be in the zero percent capital gains bracket.
Advisors and CPAs who cannot accurately explain or conduct a thorough cost/benefit analysis are doing their clients a disservice.
Thank you for the thought provoking post Michael.
You completely left out tax loss carry forwards which are beautiful
Assuming no LTCG’s during a year, would it still make sense to harvest losses (if $3,000 or less so no loss carryforwards) during a year where you are subject to a 0% LTCG rate as it will be applied against ordinary income (typically 15%)? This would lower the cost basis of the new shares, but if you expect to continue to get the 0% LTCG rate in the future (below 25% bracket), this shouldn’t make a difference. Right? Thanks as always for your great work!
Nick,
If you’ll definitely be able to apply the loss against ordinary income (and not net against 0% capital gains), yes this would still be a positive. But you’d only want to do it to the extent it doesn’t net against 0% capital gains, and only to the extent it doesn’t trigger a loss carryforward (which could net against future 0% gains).
Netting against ordinary losses, though, will still be a positive result (to the extent permissible!)!
– Michael
with possibility of lower tax rates in the future i assume better to harvest losses this year than wait correct?
Dirk,
Actually tax loss carryforwards are part of the discussion presented here. It’s the same result, just LESS valuable because you don’t even get the loss deduction now, only in the future. In fact, for many people, the only benefit they get from a tax loss carryforward is to use it to offset the gain they CREATED by harvesting the loss in the first place!
For instance, if you sell something for $70k that you bought for $100k, you may get a $30k loss carryforward, and when the thing finally recovers back to $100k you’ll have a $30k gain. Yes, the loss will offset the gain, but if you just kept the original position, you never would have had a gain in the first place (bought for $100k, sold for $100k).
However, if you harvest capital loss carryforwards and your tax rate drops, you end out being required to use your loss carryforwards against gains that might have been taxed as low as 0%, which can actually be wealth destructive.
It’s actually quite rare to get value from harvesting a capital loss carryforward that you wouldn’t have gotten by just waiting and selling the investment for a gain or loss in the future, without the transaction costs, tracking error, and risk of negative tax arbitrage.
– Michael