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Tom Talks Taxes - October 31, 2022
Does tax loss harvesting make sense for your client?
One commonly mentioned tax strategy is tax loss harvesting. On the surface, it is straightforward: a taxpayer converts accrued capital losses into recognized capital losses by selling some or all of the assets. The loss offsets current-year income, either capital gain or ordinary, and reduces current-year tax liability.
Tax loss harvesting is tempting right now as the S&P 500 index, as of October 30, 2022, is down 15.2% for the year and the NASDAQ index, as of October 30, 2022, is down 26.8% for the year.
No tax strategy works for everyone, which is also true regarding tax loss harvesting. The tax reduction may be minor for certain taxpayers, and the taxpayer has to weigh the tax savings versus the potential long-term loss in investment value.
This article will assume tax loss harvesting within a stock portfolio for a noncorporate taxpayer.
The taxpayer must sell the stock position to harvest a capital loss. In my opinion, the sale should be intentional and done for one of three reasons:
The taxpayer intends to use the sale proceeds elsewhere,
The taxpayer wants to use the sale proceeds to buy a different investment, or
The taxpayer will reinvest in the same security but plans to wait more than 30 days to repurchase to avoid loss disallowance under the §1091 wash sale rules.
Once a capital loss is recognized, netting rules apply, and tax loss harvesting planning requires intimate knowledge of these rules.
Let’s quickly review capital gains and losses before delving into the netting rules. The sale or exchange of a capital asset generates a capital gain or loss. A capital asset is any property held by the taxpayer and not excluded explicitly as capital under §1221(a). A gain or loss is long-term if held for more than one year; all others are short-term.
Long-term capital gains and losses are further separated into three buckets:
Normal rate bucket. Depending on the taxpayer’s taxable income, these gains are taxed at 0%, 15%, or 20%. This bucket will also include almost all §1231 gains characterized as capital.
Unrecaptured §1250 gain bucket. These gains are taxed at a 25% maximum rate, and this bucket has no losses.
28% rate bucket. This bucket includes gain or loss from collectibles and the sale of certain §1202 qualified small business stock.
First, short-term gains and losses are netted. If a net short-term capital loss exists, it is first applied to the 28% rate bucket, then to the unrecaptured §1250 gain bucket, and then to the normal rate bucket.
Next, long-term gains and losses are netted. A net loss from the 28% rate bucket is first applied to the unrecaptured §1250 gain bucket, then the normal rate bucket. A net loss from the normal rate bucket is first applied to the 28% rate bucket, followed by the unrecaptured §1250 gain bucket.
Last, any net overall short-term or long-term losses are netted against gains in the other bucket. If there is an overall capital loss after all netting, a taxpayer can use up to $3,000 of that capital loss against ordinary income ($1,500 on a married filing separate return), with the remainder carried forward to future tax years. In the absence of capital gains, significant capital loss carryforwards can only offset $3,000 of ordinary income per year, and they are lost if a taxpayer dies.
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To illustrate some of the considerations that need to occur for tax loss harvesting, let’s consider a few scenarios. We will only detail the federal tax impact; be sure to consider state impacts.
Example 1. Kyle, who is single, has $1,000 in long-term capital gains for tax year 2022 and is in the 12% tax bracket. If Kyle harvests $2,000 in capital losses, there is a $120 tax savings:
$0 from the $1,000 long-term capital gain (it is taxed at 0% without the loss), and
$120 from the $1,000 ordinary loss (12% of $1,000).
Example 2. Opal, who is single, has $1,000 in long-term capital gains for tax year 2022 and is in the 37% tax bracket. If Opal harvests $2,000 in capital losses, there is a $608 tax savings:
$238 from the $1,000 long-term capital gain (23.8% of $1,000), and
$370 from the $1,000 ordinary loss (37% of $1,000).
Example 3. Bart, who is single, has $1,000 in short-term capital gains for tax year 2022 and is in the 24% tax bracket. If Bart harvests $4,000 in capital losses, there is a $960 tax savings:
$240 from the $1,000 short-term capital gain (24% of $1,000), and
$720 from the $3,000 ordinary loss (24% of $3,000).
Example 4. Rose, who is single, has $1,000 in qualified dividends for tax year 2022 and is in the 32% tax bracket. If Rose harvests $4,000 in capital losses, there is a $960 tax savings:
$0 from the $1,000 qualified dividends (cannot be offset with capital losses), and
$960 from the $3,000 ordinary loss (32% of $3,000), and
$1,000 in capital loss carryforward to tax year 2023.
Example 5. Myra, who is single, has $7,000 in long-term capital losses for tax year 2022 and is in the 24% tax bracket. If Myra harvests $4,000 in short-term capital gains, there is a $1,680 tax savings:
$960 from the $4,000 short-term capital gain (24% of $4,000), and
$720 from the $3,000 ordinary loss (24% of $3,000).
Myra can repurchase the sold stock within 30 days of the original sale as the §1091 wash sale rules do not apply to gain transactions. If the stock decreases in value, Myra has a loss position that can be used in the future. Gain harvesting can create tax savings while locking in short-term or long-term appreciation in a stock position.
Taxpayers with cryptocurrency can use the above strategies; however, the §1091 wash sale rules do not apply to cryptocurrency, so there is more flexibility.
Here are three closing thoughts on tax loss harvesting:
This strategy is not a quick “tax tip” to send to clients to do on their own. Tax loss harvesting must be intentional and well-planned using solid projections.
This type of tax planning should not be free. Be sure to charge for the value you provide in a stand-alone engagement or a bundled service package.
If you assist taxpayers with this type of planning, be careful not to cross over into providing investment advice unless you are qualified to do so. If the taxpayer has a financial professional they work with, this is an excellent opportunity for collaboration to help the client with tax reduction.
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