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 tax loss harvesting is to offset capital gains against capital losses by selling those investments which are having unrealized losses thereby reducing tax liability. It is a smart way to improve tax efficiency and after-tax adjusted returns of Investments.
Taxes are levied on investor/trader on account of two types of gains made in the Securities Market which are as follows:
Gains are usually classified 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 the purpose of Tax Loss Harvesting and cannot be set off against Short term capital gains; howsoever Short term capital loss can be offset against gains made under Short Term Capital Gain and Long Term Capital Gain both.
Example of how to do Tax Loss Harvesting
Let’s understand Tax loss harvesting in a better way with the help of an example.
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 purpose 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 gain 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 such tax loss harvesting the tax liability will be reduced to $5600 ($28000*20%). Thus Tax loss Harvesting created value by reducing the tax outflow by $3600 for Frank.
Advantages of Tax Loss Harvesting
- They help in deferring of 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.
Disadvantages of Tax Loss Harvesting
- There is a limit on capital loss which can be adjusted against the capital gain during the year. As per IRS Regulation, in case of individual taxpayer maximum $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.
- Tax loss Harvesting can defer the tax outflow but can’t eliminate it altogether and one has to pay the taxes sooner or later (barring a few exceptions).
- Record keeping is a tedious task and requires the use of sophisticated tools which add up to the cost of tax loss harvesting and as such the benefits accruing gets reduced by the cost of record keeping as these are required by IRS authorities and tax department for validation purpose.
As per IRS in order to avoid misuse of Tax loss Harvesting and to ensure the same is used for a legitimate tax planning purpose and not with the intent of Tax evasion, a rule popularly known as the “Wash Sale Rule” was established which states that in order to avail the loss on sale of an investment to be adjusted against gain, it must be ensured that same or identical security is not purchased 30 days before or after the sale of such security. In case the rule is not followed, adjusting the losses from the sale of such security will not be permitted.
It is a tax-reducing strategy that is legal in nature 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 portfolio to not only generate Investment returns but also compound it by enriching the same with the amount of tax savings.
This has been a guide to what is Tax Loss Harvesting and its definition. Here we discuss how to do Tax Loss Harvesting along with examples, advantages, and disadvantages. You can learn more about accounting from following articles –