Harvest time is not over yet!
Now that Thanksgiving is behind us, and we’ve crossed the mark of December 1st, it is the official Christmas season now. We went this weekend to cut down our tree, the house is decorated, and the first Christmas party has come and gone…
BUT, at Meridian, we are still in the middle of harvest season…at every year end, we work through every client account to see if there are tax losses available for harvesting.
If you have sold investments this year, you may have realized capital gains and these are taxable at 15% of they are long term gains (on assets held more than one year) or are taxable at your ordinary income tax rate if short term.
However, one sneaky source of capital gains is mutual fund capital gain distributions. By law, mutual funds must to distribute at least 95% of any capital gain realized during the tax year. In years of large market gains and high shareholder redemptions (like 2019), many funds have realized a significant amount of capital gain and plan to distribute it to their fundholders at year end. This year end distribution of gains can be hard to plan around, as these distributions are often paid in the last week of December or the first week of January (as prior year taxable gain).
So, when available, it might be prudent to look for losses on underperforming or unfavorable stocks or funds to realize. While it is never fun to sell at a loss, the IRS does allow you to rebuy the stock or fund after 31 days to reestablish your position. If you sell a stock at a loss and buy it back before the 31 day period ends, the IRS does not allow you to use the losses on your tax return…they are considered wash sales and ignored for tax purposes.
In order to take advantage or ‘harvest’ losses, we identify a stock position that has significant embedded capital losses in a portfolio. For example, the price of Exxon has suffered over the past two quarters, falling from $80/share in April 2019 to $68/share currently. If a portfolio had added 100 shares of Exxon in April 2019, that initial $8,000 position would now be worth $6,800. We could sell these 100 shares of Exxon, and realize a $1,200 capital loss that could be used to offset any realized capital gains.
The danger in harvesting losses is that the stock recovers in price after the sale. So, to hedge against this, a common strategy is to buy a replacement security to hold for the 31 day wash sale period. The IRS does require the replacement security to not be “substantially identical”, so you cannot sell the Vanguard S&P 500 fund and replace it with the Fidelity S&P 500 fund. However, in the example of Exxon above, Chevron or another gas company could be purchased to replace Exxon in the portfolio for the 31 day wash sale period. That way, if oil stocks recover during the 31 days the portfolio doesn’t hold Exxon, all market gains are not lost.
After the 31 day wash sale period ends, the replacement stock (i.e. Chevron) can be sold and the original stock (Exxon) repurchased. So, one month later, the portfolio is back to its original positions but has used the embedded tax loss to help offset current taxes.
While tax loss harvesting is not without risks, it is a sensible strategy to consider before the year closes and Christmas decorations come down…