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Tax-Loss Harvesting: Taking Advantage of Opportunities

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Increased stock and bond market volatility can present opportunities for investors looking to reduce ordinary income or offset current and future capital gains with capital losses.

So what exactly is tax-loss harvesting (TLH)? Basically, when a fund declines significantly in value, IFA's portfolio managers can sell that fund in a client's portfolio. For tax purposes, such transactions lock-in capital losses. This drop in value can be used to then offset capital gains, and potentially, reduce ordinary income.

Any realized losses that aren't utilized in the current tax-year can be carried forward for as many years as necessary until completely used up. As a result, a market downturn provides investors with an opportunity to examine their specific tax situations and determine if they've got additional capital gains that can be offset by losses harvested for tax purposes. These capital gains might come from a variety of areas, including: fund distributions, portfolio rebalancing and proceeds from the sale of a business.

Given this tax-offset value of realized capital losses, investors need to consider a disciplined and consistent TLH strategy after stock or bond positions have experienced a large enough decline. In a nutshell, below is a basic overview of how our process works and IFA's research methodology supporting tax-loss harvesting. 

First, our portfolio managers will sell equity index funds in clients' taxable accounts that have declined in value by approximately 10% or more and have a minimum capital loss of $5,000. For fixed-income funds, the percentage criterion can be as low as 5% and $5,000. At IFA's discretion, such criteria might change as market conditions warrant. This sale will create a realized short-term capital loss on the sold funds held for less than 12-months and a long-term capital loss on sold funds held more than a year. 

The proceeds will be invested into a different alternate fund. By IRS rules, these changes can't be made into a "substantially identical" investment. As a result, IFA's portfolio team substitutes funds that are intended to follow such tax guidelines without sacrificying asset-class diversification.  

For example, we might choose to sell a client's position in the DFA Tax-Managed U.S. Equity (DTMEX) fund and re-invest those assets into another U.S. large-cap fund, the DFA U.S. Large Company Portfolio (DFUSX). That's just one possible substitute we've identified, though. As part of our ongoing TLH review process, IFA's portfolio management and research group keeps refining its list of replacement funds in different asset classes. These TLH fund choices are made with input from John Dahlin, head of IFA Taxes, and a certified public accountant (CPA). 

After 31 days, we'll liquidate the alternate fund and use the proceeds to repurchase the original fund. The aim of this process is to ensure that an investor's overall risk capacity will be in alignment with the asset-allocation of the original IFA Index Portfolio. 

This 31-day period avoids the IRS Wash Sale Rule, which states that a wash sale occurs when you:

  • Purchase the same securities within 30 days before-or-after the sale.
  • Buy or otherwise acquire "substantially identical securities" within 30 days before-or-after the sale in any account. (If you buy the substantially identical stock in your IRA, you also have a wash sale.)

A gain/loss report and a 1099 from each client's custodian will indicate the gains and losses for the tax year. Individuals can use up to $3,000 of capital losses to offset their ordinary income in any given tax year ($1,500 for a married person filing separately). If you realized $10,000 in capital losses, a taxpayer would be able to apply $3,000 of their net capital loss to reduce their current taxable income, leaving $7,000 in unused net capital loss to offset current tax-year capital gains or carry forward for future tax years. 

Tax-loss harvesting is not market timing. By purchasing an alternate index fund, investors can remain fully invested in the market. 

While tax-loss harvesting is a valuable tool, there are some risks associated with it. As such, you should carefully consult with an IFA wealth advisor prior to making the decision to undertake this process. Assuming all long-term losses are used to offset existing long-term gains, examples of such risks include:

1.) Take a fund that's sold at a 10% long-term capital loss and those proceeds are temporarily re-invested in an alternate fund. If that alternate fund increases by 5% during the 31-day interval, such a gain can be expected to be used to offset a portion of that long-term 10% capital loss from the sale of the original fund. So your resulting benefit in this example would be a 5% capital loss that could be used to offset capital gains and/or reduce ordinary income. 

IFA's tax-loss harvesting strategy was developed to produce an 90% probability of positive net outcomes for our clients. However, it takes into account that market volatility may prevent TLH from proving beneficial 10% of the time.  

2.) During the minimum 31-day interval required to book losses, the alternate fund will almost certainly obtain a different return than the funds sold. This isn't surprising since these temporary alternate funds use "not substantially identical" securities. Such a risk is the only reason the IRS allows this loss to be kept by investors.

3.) There are transaction fees to be paid to the custodian (Schwab, TD Ameritrade or Fidelity). No additional fee is paid to Index Fund Advisors.  

Applied in a consistent manner, our studies of actual outcomes of IFA clients indicate that TLH produces positive benefits over extended periods. We highly recommend that investors check with an IFA wealth advisor and a tax professional to make sure booking losses against any possible capital gains fits with their longer-term financial and tax planning goals. IFA Taxes, our tax-planning and preparation division, offers free initial consultations. You can reach CPA Dahlin by email at [email protected] or phone at (888) 302-0765. 

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There are no guarantees investment strategies will be successful.  Investing involves risks, including possible loss of principal. This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.