Though it’s hard to imagine that a drought could ever be a good thing, experienced livestock ranchers know that dry spells are going to come along periodically. In fact, they also know that a drought can be the ideal time to get ready for the time when the rains start to fall again. During a drought, they will make sure their water reservoirs are in good shape; sometimes they will dig new ones. They will often pay especially close attention to pasture rotation so that when moisture is more plentiful, their grazing resources will be in the best shape possible.
In many ways, a down market can be viewed similarly. Of course, it’s never fun to see the value of your portfolio fall. Experienced investors know that, while historically, markets tend to go up more often than they go down, occasional price drops are inevitable. And during down market cycles—“droughts,” you might call them—there are techniques that can help you get ready for the next upswing. One of the most important of these is tax-loss harvesting.
Keep in mind that tax-loss harvesting strategies contemplate two types of taxes: long-term capital gains and short-term capital gains. Long-term capital gains are taxed at one of three rates, depending on your other income: 0%, 15%, or 20%. If you are in a higher marginal tax bracket, even the maximum capital-gains tax rate is probably less than your tax rate for ordinary income. Long-term capital gains taxes apply to gains on assets held for a year or more. Gains on assets held for less than a year are subject to the short-term capital gains tax rates, which are the same as the taxpayer’s ordinary income tax rate.
How does it work? Suppose you have sold Mutual Fund/ETF A, which you owned for over a year, and you booked a capital gain of $100,000 on the sale. If you do nothing, you will pay tax on that gain at whatever long-term capital gains tax rate applies to your income bracket (likely either 15% or 20%). However, suppose you also own Mutual Fund/ETF B, also held for over a year, which has an unrealized capital loss of $50,000. You might wish to “harvest” that loss by selling Mutual Fund/ETF B and use it to offset the gain in Fund/ETF A, reducing the amount of your taxable long-term capital gain by half. That, in its simplest form, is how tax-loss harvesting works.
Recent studies have shown that when properly applied, tax-loss harvesting can add significantly to the performance of a stock portfolio versus typical benchmarks (this difference is usually referred to as “alpha”). In a 2020 study at MIT, for example, researchers found that a tax-loss harvesting strategy produced a “tax alpha” of between 0.85% and 1% per year. Over time, tax savings at this level can make a big difference in the long-term return of a portfolio.
Those who utilize tax-loss harvesting strategies may want to replace the asset that they sold at a loss so that their asset allocation remains within strategic guidelines. To do this, however, you must wait at least 30 days after a sale before repurchasing the asset. Another option is to replace the asset with another that is not “substantially identical,” in IRS terminology, in order for the loss to be recognized (these issues pertain to the “wash sale rule”).
Short-term capital losses (on assets held less than a year) may also be used to offset gains, but they must first be allocated against short-term gains, if any. Any remaining short-term losses may then be applied against long-term gains. Conversely, long-term losses can be used to offset short-term gains, but only after they have been applied to any available long-term gains.
At this point, our “drought” analogy comes into sharper focus. Later, when the market regains upward momentum, the portfolio will once again begin showing gains. Eventually, rebalancing will be required in order to keep the asset allocation within strategic guidelines. The sale of assets will likely be required, which could generate capital gains (and the potential need to write a bigger check to the IRS). But with prior tax-loss harvesting, a portion of those gains can be offset, alleviating or greatly reducing the investor’s tax bill on realized gains.
And by the way, if in a given year you aren’t able to utilize all your losses against capital gains, you can carry them forward to offset up to $3,000 of ordinary income or investment gains for a future tax year. In other words, tax-loss harvesting doesn’t have to be a “use it or lose it” proposition.
At Bondurant Investment Advisory, we help clients develop strategies that enable them to let the markets work for them, rather than against them. This strategy is particularly effective when BIA is able to manage client’s assets holistically in order to maximize finding assets with losses to offset gains. To learn more, read our recent article, “Mean Reversion: Unlocking a Foundational Investing Principle.”
