What is Tax Loss Harvesting?
Tax Loss Harvesting is a popular strategy wherein the loss-making securities are sold in order to reduce the tax liabilities arising on account of gains made in the other securities. The basic rationale behind this is to offset capital gains against capital losses by selling those investments which are having unrealized lossesUnrealized LossesUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal. thereby reducing tax liability. It is a smart way to improve tax efficiency and after-tax adjusted returns of Investments.
Taxes that levy on investor/trader are on account of two types of gains made in the Securities Market, which are as follows:
Gains usually classify under the below mentioned two categories; however, the criteria differ from one jurisdiction to another. For simplicity purpose, we have taken US jurisdiction for classification purpose:
- Short Term Capital Gain/Loss: Any purchase or sale in security, which is held for less than a year resulting in gain/loss is categorized under Short Term Capital Gain/Loss.
- Long Term Capital Gain: Any purchase or sale in security, which is held for more than a year resulting in gain/loss is categorized under Long Term Capital Gain/Loss.
It is pertinent to note here that Long term capital loss can be set off only against long term capital gain for Tax Loss Harvesting. It cannot set off against Short term capital gains. Howsoever Short term capital loss can offset against gains made under Short Term Capital Gain and Long Term Capital Gain both.
How does Tax Loss Harvesting work?
Frank holds a portfolio of stocks comprising of 5 stocks. During the year his performance in different stocks in his portfolio is as follows:
Frank has made a realized gain of $45000 during the year on shares bought and sold by him. For simplicity purposes, let’s assume all the gains made are short term in nature, and the applicable tax rate is 20%.
Tax to be paid on Short Term Capital Gain= $45000*20% =$9000.
Now let’s understand how Tax-loss harvesting results in lower tax outflow for Frank. Suppose Frank sold off his holding in Boeing and Chegg also which resulted in Net 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 $28000 ($45000-$17000) and utilized the proceeds to buy shares of some other company which is highly correlated to the sectors of Boeing and Chegg thereby ensuring the portfolio risk levels remains same.
By doing so, the tax liability will be reduced to $5600 ($28000*20%). Thus it has created value by reducing the tax outflow by $3600 for Frank.
- They help in deferring Income-tax liability, which indirectly results in increasing the tax-adjusted returns for the Investor.
- Their returns can be maximized if the Investor never intends to liquidate its portfolio and continue to hold it till retirement as his/her taxable income will be minimal post-retirement.
- It is useful for those investors who frequently make short term capital gain, which attracts higher tax rates. By making use of this strategy, their tax outflow gets reduced substantially.
Some of the disadvantages are as follows:
- There is a limit on 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., which can be adjusted against the capital gain during the year. As per IRS Regulation, in case of individual taxpayer maximum of $3000 loss can be adjusted during the year ($1500 each if married couples are filing separately). Thus not all capital loss can be adjusted against the Capital gain, thereby limiting tax-loss harvesting benefits.
- Tax-loss requires selling and buying of securities which are loss-making and adjusting them with profit-generating securities. Such buying and selling involves costs and sometimes outweigh the benefits arising out of such tax-loss harvesting.
- It can defer the tax outflow but can’t eliminate it, and one has to pay the taxes sooner or later (barring a few exceptions).
- Recordkeeping is a tedious task and requires the use of sophisticated tools that add up to the cost of tax-loss harvesting. As such, the benefits accruing gets reduced by the cost of record-keeping as IRS authorities, and the tax department requires these for validation purposes.
It is a tax-reducing strategy that is legal and is not based on any type of speculation. A smart investor can make effective use of this strategy to compound its tax-adjusted return. Also, this strategy helps in an investment portfolioInvestment 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. to not only generate Investment returns but also compound it by enriching the same with the amount of tax savings.
This article has been a guide to what is Tax Loss Harvesting and its definition. Here we discuss how it works along with examples, advantages, and disadvantages. You can learn more about accounting from following articles –