What Is Tax Loss Harvesting?
Tax loss harvesting refers to making up for the expected losses on one investment with the realized profits on other investments to offset the net profit, which is finally the taxable income. Tackling the losses using the huge gains lowers the net income for the entity, thereby reducing its tax liability.
Tax loss harvesting allows investors to play smart and protect their profits to a significant extent. They sell their failing assets and invest the funds accumulated in purchasing the profitable ones that would help them earn profits in the later stage.
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- Tax loss harvesting is a popular strategy wherein the loss-making securities are sold to reduce the tax liabilities arising from gains made in the other securities.
- The basic rationale behind this is to offset capital gains against capital losses by selling those investments with unrealized losses, thereby reducing the tax liability.
- It is a smart way to improve investment efficiency and after-tax adjusted returns.
- Short-term and long-term are the two types of tax loss harvesting observed in the United States.
How Does Tax Loss Harvesting Work?
Tax loss harvesting allows investors to sell their assets that are likely to fail and use that amount to purchase those stocks that appear profitable in the long run. This gives investors a chance to show their net profit as the difference between the amount reaped as gain and the amount incurred as loss and, therefore, register the differential amount as their taxable income. In short, this method of harvesting tax losses lets investors offset their taxes.
It is a tax-reducing strategy that is not based on speculation. Therefore, a smart investor can use it effectively to compound its tax-adjusted return. It also helps an investment portfolio generate investment returns and compound them by enriching them with tax savings. Investors use this strategy to offset future losses, thereby reducing future gains and helping in future tax savings.
This tax-saving method works effectively for investors who hold securities in their taxable accounts. They can utilize these losses incurred to save on taxes and turn the negative results into positive ones. Above all, tax loss harvesting in crypto is gaining momentum, given the willingness of investors to invest in these currencies. Here, investors sell assets at a loss and offset capital gains from various investment portfoliosInvestment PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor's risk profile..
Tax loss harvesting rules are necessary to be aware of as it does not allow investors the liberty to buy or sell stocks anytime based on the realized losses and profits. An investor cannot sell a stock, realizing a loss to reduce the tax liabilities, and then buy the same or similar stocks later. This restriction put on the intentions of investors is termed wash sale.
The wash sale ruleWash Sale RuleThe Wash Sale Rule is a regulation laid down by the Internal Revenue System (IRS) of the United States that disallows a tax deduction when an investor sells a security at a loss and then buys the same or identical security from the market within 30 days. applies when investors sell securities at losses and buy or acquire an options contract to purchase identical securities within 30 days before or after the sale. However, this tax loss harvesting limit does not restrict investors from buying stocks/securities in the same industry.
Let us consider the following tax loss harvesting example to see how it is calculated:
Frank holds a portfolio comprising five stocks. During the year, the performance of different stocks in his portfolio is as follows:
Frank had made a realized gainRealized GainWhen an asset is sold for a higher price than when it was purchased, it is referred to as a realized gain. Because the seller gains from the transaction, this gain is taxed, however an unrealized gain is not taxable because it is valued at fair market value. of $45000 during the year on shares he bought and sold.
To make it simple, let’s assume all the gains made are short-term, and the applicable tax rate is 20%.
Tax on Short Term Capital Gain= $45000*20% =$9000.
Let’s understand how tax-loss harvesting results in lower tax outflow for Frank. Suppose Frank sold off his holding in Boeing and Chegg, resulting in a net realized gain of $28000 ($45000-$17000). He then utilized the profits to buy shares of other companies from a similar sector to ensure the portfolio risk levels remained the same.
Doing so reduces the tax liability to $5600 ($28000*20%). Thus, it creates value by reducing Frank’s tax outflow by $3600.
The tax loss harvesting technique helps defer tax liabilityDefer Income-tax LiabilityDeferred tax liabilities arise to the company due to the timing difference between the accrual of the tax and the date when the company pays the taxes to the tax authorities. This is because taxes get due in one accounting period but are not paid in that period., indirectly increasing the tax-adjusted returns for investors. The returns maximize if they do not intend to liquidate their portfolio and continue to hold it until retirement, as their taxable income is likely to reach the minimum post-retirement. In addition, it is useful for those who frequently make short-term capital gains and attract higher tax rates. Using this strategy, their tax outflow reduces substantially.
Besides reducing the tax burden for the investors, this strategy also lets them keep their portfolios balanced by buying, selling, and rebuying stocks from time to time.
Tax Loss Harvesting Short-Term and Long-Term Losses
Gains subject to tax loss harvesting are usually classified into two categories. However, the criteria differ from one jurisdiction to another. The U.S. jurisdiction classifies it as:
- Short-Term Capital Gain/Loss: Any purchase or sale in a security held for less than a year, resulting in gain/loss, is a short-term capital gain/loss. Here, the normal income tax rate applies, i.e., 10-37% based on the income group one belongs to.
- Long-Term Capital Gain: Any purchase or sale in security that investors hold for more than a year, resulting in gain/loss, falls under long-term capital gain/loss. In this case, the income tax rate can be as low as 0% but will not exceed 20%.
The investors, however, can use only long-term capital gains to set off long-term capital gains. It means they cannot use a short-term capital gain to offset long-term capital lossCapital LossCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets. or long-term capital gain to offset the short-term capital loss.
Frequently Asked Questions (FAQs)
Tax loss harvesting is a smart decision so far as keeping the financial planning intact is concerned. However, selling stocks and realizing the associated loss every time might not be a good option, given the intention is only to have reduced tax burdens. However, if there is an additional benefit or motive behind doing it, harvesting tax losses is perfectly worth it.
Investors can achieve the best benefits of harvesting tax losses by following a proper process. Firstly, they should sell the expected loss-incurring stocks, have the amount preserved, and then spend the same on buying other stocks, realizing the associated gains.
The US federal tax law makes it completely legal to offset capital gains with the losses incurred by selling securities during a particular tax year. It can also include the offsetting carried over from a prior tax return.
This article is a guide to what is Tax Loss Harvesting. Here, we explain how it works along with its rules, an example, benefits, and short- & long-term losses. You can learn more about accounting from the following articles –