When you have a profit in the stock market, you're not the only winner. The Internal Revenue Service also gets to collect a portion of what you made from your asset's appreciation through the capital gains tax. However, they also let you subtract your losses from your gains to reduce your capital gains liability. This leads to a practice called tax loss harvesting.
Tax Loss Harvesting
The practice of tax loss harvesting involves matching gains and losses so that you can take gains without paying taxes by offsetting them. For example, if you have 500 shares of stock or a mutual fund that you bought for $50 a share and that has dwindled to $30, you could sell that stock and claim a $10,000 loss in addition to receiving your $15,000. This lets you sell a block of appreciated stock on which you want to take your profits -- like 250 shares of a $50 stock that you bought for $10. The $10,000 profit gets cancelled out by the loss, leaving you with a profit and no tax liability.
The Wash Rule
Harvesting tax losses leaves you with cash instead of the investments that you originally held, and the IRS doesn't allow you to turn around and re-buy the same stock. Its wash sale rule means that you must wait over 30 days to reinvest the funds in the same stock. If you don't, the IRS will disallow your loss and act as if you had never sold the stock at a loss. Furthermore, the IRS wash sale rule prevents you from buying "substantially similar" investments, though, so you also can't turn around and buy the same mutual fund from a different company, for example.
If you're selling a company that you held for a long time at a loss and you still want to own it, waiting 31 days to rebuy the stock might be an acceptable alternative. You could also make a different investment either for the period that you need to wait or to replace the stock. Alternatively, you can make another investment. Traditionally, you would sell one stock and buy one in a similar company -- like selling Pepsi and buying Coke or selling Mercedes-Benz ADRs and buying BMW stock. However, selling one firm's S & P 500 index fund and buying another one's could be a violation of the wash sale rule. As such, you will need to have a suitable replacement investment that is different enough to pass muster.
Tax-loss harvesting isn't technically a tax avoidance strategy. When you take your loss and reinvest the money, you reinvest it at a lower basis; if, as you hope, the replacement stock you buy goes up in value, you'll end up paying capital gains tax on the bigger profit. In essence, with tax loss harvesting you are deferring gains, and taxes, into the future. Among the risks of this strategy is that capital gains tax rates could go up on your deferred gains.
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