How Tax-Loss Harvesting Works
By John Owens, CFP, EA, ECA, CPWA
January 2022 was a bumpy month in the market - it found some sell-offs in major asset classes at levels we haven’t seen since March 2020 (hold my beer!). With volatility often comes opportunity - the chance to rebalance, unwind a concentrated stock position at a smaller tax bill, and to tax-loss harvest. Tax-loss harvesting has been a buzzword in the industry for quite some time - but many folks struggle to understand the concept and how it actually works. And implementing tax-loss harvesting without knowing what you’re doing can truly spell disaster.
Watch out for Wash Sales
Before we jump into the mechanics of how this works (and doesn’t), there are a few tax concepts we need to understand. The most important one is called a wash sale. The wash sale rule prohibits you from taking losses in stock sales or trades when - within 30-days before or after the sale, you buy a ‘substantially identical stock or security’, acquire substantially identical stock or security in a fully taxable trade, acquire a contract or option to buy a substantially identical stock or security, or acquire a substantially identical stock or security in your IRA or Roth IRA.
That sounds all well and good - but what are they really saying? They’re saying that if you bought stock in XYZ corporation at $15/sh two years ago, sell it today at $10/sh. An then buy XYZ corporation stock tomorrow at $8/sh, you can’t take the loss of $5/sh on yesterday’s sale against your investment income. How come? Because in their eyes, your economic position hasn’t really changed - you still own XYZ corporation stock - and therefore can’t get a tax benefit. When this happens, the $5/sh loss on ‘yesterday’s’ sale gets added to your cost basis of $8/sh on today’s purchase. You don’t lose the loss altogether, you simply have the loss suspended until you sell the shares purchased today (assuming you don’t buy them back within the next 30-days of that sale).
How it applies to Stocks
Whew - that’s a lot. So, that’s it, right? Not exactly. Let’s try a slightly different exercise. Let’s pretend XYZ Corporation is Coca Cola. And let’s pretend that everything else is the same in the previous example except that the next day we buy Pepsi stock instead. Was that a wash sale? No - it wasn’t. While Pepsi and Coke both produce beverages and snacks, and are competitors, the IRS does not consider them substantially identical. They each have different valuations, PE ratios, corporate structures, strategic initiatives, customer bases, etc. So you can, in theory, swap out Coca Cola at a loss and buy PepsiCo without triggering a wash sale. But you can’t do it with Coca Cola and Coca Cola.
That being said, we really live in a world where ETFs have become one of the primary vehicles through which individuals and institutions invest. Can we tax-loss harvest with them?
How it applies to ETFs and Index Funds
Let’s walk through an ETF example. The largest ETF by assets is the SPDR S&P 500 ETF (SPY) that, as you can see, is designed to track the S&P 500 index. Say you purchased SPY in early January 2022 at $470/sh, and then fully liquidated the position by executing a tax-loss harvesting trade to sell SPY in late January at $435/sh - triggering a $35/sh short-term loss. At this point, you haven’t triggered a wash-sale. But what happens next will determine your fate. Let’s say you take those funds and put them into VOO - Vanguard’s S&P 500 ETF on February 1st. In that scenario, you will have triggered a wash sale and your $35/sh loss would be disallowed and added to your cost basis in VOO. But wait, you ask - they are different ticker symbols - like Coke and Pepsi? While they are different ticker symbols, both of these funds are designed to track the same index - at the end of the day you still own the S&P 500.
Instead, you may opt to sell SPY and buy something similar, but not substantially identical. One option might be to purchase the Russell 3000 index (IWV). The Russell 3000 tracks the largest 3,000 publicly traded US stocks, which is a different composition from the S&P 500 - with 6-times the holdings. While this will adjust the composition of the portfolio, it will allow the funds to stay invested in the same asset class while also maintaining the tax loss.
In order to be effective at tax-loss harvesting, especially in an index-based portfolio, it’s important to identify the investment options that can be used to swap out indices when loss harvesting while also keeping the portfolio composition on track. At Brooklyn FI, we’ve identified several tax-loss harvesting strategies for each of the major asset classes so we can move quickly when volatility strikes - and help our clients save on their tax bill.
Common Misconceptions
Now that we understand the concept of tax-loss harvesting, I want to cover a few misconceptions about the strategy.
When I disqualify my ISOs in the same tax year that I exercised them, I get a short-term capital loss. False - disqualifying dispositions of ISOs are ordinary income and will not show up on your Schedule D as a capital gain or loss if done in the year of exercise.
If I do this in two separate accounts - take the loss at TD Ameritrade and buy the stock back at E-Trade, it is not a wash-sale. False - even if the custodian does not know it is a wash-sale, it is the taxpayers responsibility to report it as such on their return.
Tax-loss harvesting can help offset my RSU income this year. Maybe, but not as much as you might think. When RSUs vest, they become ordinary income. Tax-loss harvesting produces capital losses. Capital losses can only offset other capital gains, and then up-to $3,000 of ordinary income. Losses above that are carried forward to future tax years.
My spouse can just buy the same security in their account. False, wash sales apply to both you and your spouse, so you cannot take a loss and have your spouse buy a substantially similar security.
Tax-loss harvesting only makes sense at year-end. Not true, it makes sense to review for losses year-round to better optimize your tax bill. There’s no guarantee that there will be losses to take at year-end.
As you can tell, tax-loss harvesting is a valuable and complicated strategy. For our investment management clients, we take the stress and hassle out of tax-loss harvesting and proactively implement the strategies that make sense when volatility strikes. To learn more about tax-loss harvesting, reach out to one of our advisors.