Tax loss harvesting is the sale of securities in a taxable account that have declined in value since their purchase in order to recognize the loss for tax purposes. Most people (including professional financial advisors) do this at the end of the year determining whether the transaction is worthwhile by comparing the immediate tax savings to the transaction cost. This is not optimal two different ways.
First, positions should be evaluated throughout the year for opportunities to save on taxes; there is no reason to wait until the end of the year. Because investments tend to go up more than down and there is little serial correlation in the market, taking losses when they are economically meaningful is prudent.
Second, the calculation of tax savings and costs is more complicated than it first appears. Consider first the standard analysis:
- Assume the original investment was $10,000.
- The investment has declined in value to $9,000.
- The investor is in the 15% tax bracket (i.e. this will offset other long-term capital gains).
- An equally attractive alternative investment that is not a wash sale violation is available.
- The transaction costs are $20 for each trade ($40 total – one sell and one buy). Transaction costs should include not only the explicit commissions but also bid/ask spread costs and market impact costs.
This appears to be the proverbial “no brainer” – spend $40 to save $150 (a $1,000 loss times 15% tax savings).
In fact, given the information above, whether this is a prudent strategy or not is undeterminable. Three key pieces of information are missing:
- How long does the investor expect to keep the “old” investment in their portfolio if they don’t harvest the loss?
- What will the tax bracket be at that time for that transaction?
- What is the hurdle rate for the return on this strategy?
Let’s assume if the investor doesn’t sell to take the loss it would be sold in 5 years anyway for some reason (perhaps we estimate this by simply knowing the investor has a 20% portfolio turnover rate). Further, assume the tax bracket at that time will continue to be 15%. The future transaction costs aren’t relevant since it will be sold at that point anyway – it doesn’t matter which investment it actually is.
At this point, it is simply a time value of money problem. With tax loss harvesting, the investor saves $150 in taxes now less the $40 for transaction costs for a net of $110. However, in 5 years the cost basis is $1,000 lower than it would have been had the old investment been kept. Thus, the tax bill at that time is $150 higher than it would have been. Essentially the $110 now cost $150 in five years.
Since the rate of return that will grow $110 to $150 in 5 years is 6.40%, this selling is only advisable if the current tax savings can be invested to earn more than 6.40%. Alternatively, it can be viewed as an opportunity to borrow at 6.40% for 5 years. That might or might not be attractive depending on the situation.
To recap, tax loss harvesting is more attractive to the extent:
- The loss to be harvested is large.
- The transaction costs are low.
- The alternative investment is attractive.
- Future tax rates will be low.
- The investment will probably be held for a long time.
Conversely, tax loss harvesting is unattractive if:
- The loss to be harvested is small.
- The transaction costs are high.
- The alternative investment is unappealing (such as keeping cash for 30 days to avoid the wash sale rules and then repurchasing the original investment).
- Future tax rates will be high.
- The investment will be sold shortly anyway for unrelated reasons.
Tax gain harvesting is potentially advantageous when a taxpayer finds themselves facing a lower rate in a particular year than they are likely to face in the near future. The optimal strategy is frequently to harvest those gains and pay the taxes early, but at the lower rate. For investments that will be held for the long term, but not too long, it may be optimal to sell and lock in the gain at the lower rate and then immediately repurchase the investment. This would mean that only future gains will be taxed at the higher rate.
To prevent taxpayers from selling investments at a loss to get the tax deduction and then immediately repurchasing the investment (or doing something roughly equivalent economically) there are what are known as “wash sale rules” that disallow taking the deduction until the investment is “really” sold. These rules do not apply to recognizing capital gains.
Many investors may have large carryforward losses. The current tax code only allows the recognition of $3,000 per year of capital losses against ordinary income. The remainder is carried forward to future years where it may be used against subsequent recognized gains. For taxpayers in this situation, recognizing gains early will not be advantageous as they are not actually being taxed at the long-term gain rate, but rather simply using up some of the accumulated losses.
Assume a stock was bought for $50,000 and is now worth $150,000 and would incur taxes of $15,000 (a 15% rate) if sold this year and that the same sale in the future would incur taxes of $20,000 (a 20% rate). If it is anticipated that the investment would be sold in ten years but instead is sold now and repurchased, the investor pays $15,000 today to avoid taxes of $20,000 in ten years. That is a rate of return of just 2.92% (annualized). It would probably be better to invest the $15,000 instead of paying taxes and earn enough to pay the $20,000 later with money left over. (This simplistic analysis ignores transaction costs from the “extra” trades and taxes on the alternative investment, so the return is slightly overstated.) Conversely, if it is anticipated that the investment would be sold in two years rather than ten, the rate of return is 15.47% (annualized). That is compelling. To recap, capital gain harvesting is more attractive to the extent:
- There are substantial embedded capital gains on investments in a taxable account
- The investor does not have offsetting recognized losses or loss carryforwards
- The investment will be sold anyway in a relatively short period of time.