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What is Tax Loss Harvesting?
What’s important to know about it?
In this article, I will break down the meaning of Tax Loss Harvesting so you know all there is to know about it!
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Table of Contents
What Is Tax Loss Harvesting
Tax loss harvesting refers to the practice of selling an asset or securities at a loss with the aim of offsetting gains resulting from the sale of other securities.
In other words, an investor will deliberately sell securities at a loss to offset gains generated by the sale of other securities.
For example, if you have Stock A and Stock B in your portfolio where Stock A is $5,000 in the money and Stock B is losing $5,000, by selling both securities, you will effectively offset your $5,000 gain with a $5,000 loss.
This way, you will not have to pay any taxes on the sums collected.
The tax loss harvesting strategy is generally used to reduce the amount of short-term capital gains owed although investors can use this strategy for long-term capital gains as well.
The main objective of tax loss harvesting is that an investor can limit or reduce his or her tax liability by deliberately offsetting capital gains with capital losses.
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How Does Tax Loss Harvesting Work
The way tax loss harvesting works is that an investor will deliberately sell securities at a loss with the objective of reducing tax liability owed on other securities sold for a profit.
In many cases, sophisticated investors using this strategy will wait until the end of the year to assess where they have generated gains in their investment portfolio and if there’s a potential for selling securities to reduce their tax obligations.
When an investor sells a stock or securities at a loss, he or she will use the value of the “loss” and apply that as a credit against “gains” other investments.
Keep in mind that tax loss harvesting is a strategy to reduce your overall taxes payable.
If you have securities in your portfolio that are showing paper losses but have the potential for future returns, you have to decide if it’s worth selling them at a loss to offset your taxes or wait and sell those for a profit in the future.
Since you need to sell securities to generate losses, you should carefully decide which securities you may want to deliberately sell to generate a loss.
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Wash-Sale Rule And Tax Loss Harvesting
Investors adopting a tax loss harvesting strategy should be aware of the Wash-Sale Rule.
The Wash-Sale Rule applies when an investor sells a stock or security and purchases other stocks or securities that are “substantially identical” to the one sold within thirty days.
If the sale and purchase transaction is considered a “wash-sale”, then the investor cannot apply the tax loss generated by the sale against gains.
For example, an investor may sell a stock and purchase call options on the same stock within 30 days.
The fact that the investor sold stock and acquired options on the same stock may be considered as a purchase of securities that are substantially similar to the one sold triggering the application of the Wash-Sale Rule.
Most investors may not have to worry about a wash-sale to the extent they sell stocks that they do not buy back.
However, traders and more advanced investors practicing tax loss harvesting and other strategies should be cautious to avoid any unintended costs.
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How Much Tax Loss Harvesting Can You Do
Every tax jurisdiction will have its own rules applicable to tax loss harvesting.
In the United States, the IRS has adopted a rule where a taxpayer cannot offset more than $3,000 in short-term losses against short-term gains.
In a similar fashion, a taxpayer cannot write off more than $3,000 of long-term capital losses against long-term capital gains.
In regard to long-term capital losses, you may have the ability to carry them forward to future tax years.
It’s important that you review the applicable tax rules to see how much capital gains you can offset and if you can carry any losses forward.
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Tax Loss Harvesting FAQ
What does tax loss harvesting mean?
Tax loss harvesting is a strategy where you sell underperforming investments to offset gains on better performing investments.
Investors having a taxable investment account can benefit from this strategy to reduce their overall tax liability.
Typically, an investor will sell underperforming investments, take advantage of the losses to mitigate taxes on other gains, and reassess their portfolio strategy going forward.
How does tax loss harvesting help reduce taxes owed?
You can reduce your overall tax bill by selling an investment for a loss so you can offset the sale of another investment for a profit.
For instance, if I sold Stock A for a profit of $10,000 where I have to pay 20% in capital gains taxes ($2,000 in this case), I can sell another stock in my portfolio for a loss to reduce my tax obligation.
If I sold Stock B for an $8,000 loss, I can then use a credit of $1,600 against the $2,000 tax that I owe, netting me a total tax of $400.
When to use tax loss harvesting?
Although the main reason for an investor to use tax loss harvesting is to effectively take advantage of tax losses to offset profits, an investor can also use it to refocus their portfolio investment strategy.
In other words, an investor can carefully devise an investment portfolio and if there are consistently underperforming stocks, the investor can choose to liquidate the underperformers to better focus the portfolio investment strategy going forward.
Investors that are in a high tax bracket will have a greater interest in using this strategy than those in lower tax brackets.
Should you sell a losing stock for a tax break?
Just because you can sell a losing stock to get a tax break does not mean that you should go ahead and sell the stock.
If you are investing, you should generally consider generating value long-term.
As a result, a stock may be currently underperforming but may have a significant upside in the future.
If you sell the stock today, your benefit will be very small compared to keeping the stock and earning a significant profit in the future.
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So there you have it folks!
What does tax loss harvesting mean?
In a nutshell, tax loss harvesting is an investment strategy where an investor sells an investment at a loss to offset gains realized on other investments.
For example, an investor may sell stocks for a loss to offset profits generated on the sale of other stocks.
Tax loss harvesting essentially allows you to reduce your total tax bill.
The way it works is that you sell an investment that is not performing to your standards and is losing money, you use the loss to offset your ordinary income for up to $3,000 per year, and eventually you reinvest your money into an investment that better fits your requirements.
Now that you know what tax loss harvesting means and how it works, good luck with your research!
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