As an investor, it can be hard to sell an asset that’s gone down in value since you bought it. Your instinct may be to hold it for a while longer in case the price goes back up – and that’s perfectly normal.

In some situations, however, there may be advantages to selling those depreciated investments rather than holding on to them. Through a strategy called tax-loss harvesting, your losses potentially can provide you with some relief from capital gains taxes and reduce your taxable income.

Like all matters tax related, tax-loss harvesting can be complicated. Here are some key aspects to know about the concept and how it can be a valuable approach in both up and down markets to allow you to keep more of what you make.

How does tax-loss harvesting work?

Tax-loss harvesting involves selling an asset that has fallen in value, such as during market downturns, to book a capital loss for tax-reporting purposes. Your capital loss usually is the difference between what you paid for the asset – otherwise called your cost basis – and the price that you sold it for. For example, if you bought 100 shares of a stock when it was at $100 and then sold those shares when it was at $75, your overall capital loss would be $2,500 (100 x $25).

Claiming that loss allows you to reduce your taxable capital gains (what you make when you sell an asset for more than you bought it), as well as potentially offset up to $3,000 per year of your taxable personal income. Additionally, you can reinvest the proceeds from your sale back into your portfolio to avoid missing out on market performance.

Tax-loss harvesting, when done correctly, can help you keep more of your hard-earned dollars that you would otherwise owe as taxes. In fact, Vanguard and other independent organizations estimate that astute tax-management can add as much as 0.75% to an investor’s annualized returns.

Long term, there’s no limit to the losses you can harvest

In a single tax year, losses are limited to offsetting capital gains and the $3,000 annual limit against your taxable income. In other words, if you had $7,000 in capital losses in a year, you could use that to offset up to $4,000 in capital gains as well as write off $3,000 against your taxable income.

However, losses over that limit can be banked for future use and carried forward until capital gains occur, which could be the next year or even several years down the road.

There are restrictions to be aware of, though

In order to realize a loss, there is a rule in place to make sure investors don’t simply capture an accounting loss on an asset they'll then turn around and buy again right away. The wash-sale rule states that an investor cannot sell an asset and repurchase the identical asset within 30 days before and after the accounting loss was recorded. That 30-day window applies to all of your accounts, including non-taxable and spousal accounts.

Capital gains and losses often don't add up to your actual investment performance

Keeping track of your capital gains and losses is necessary for tax purposes, but it’s important to remember that your gains and losses rarely equate to your actual investment performance, as the cost basis for most investments excludes dividends, interest and distributions. If those cash flows are reinvested, each purchase will then have its own unique cost basis, as the purchase occurred at a different price.

However, while cost basis doesn't equate to performance, it will align with your tax bill over the long-term. Thus, selling an asset that has a higher cost basis than the current stated value can significantly impact what you owe in state and federal taxes this year and in future years.

Tax-loss harvesting is complex, but in certain situations it may be a useful tool for investors to keep more of their money on an after-tax basis while maintaining the same level of long-term risk/return in their portfolio.

Contact me to learn more!

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