Understanding the buzzword: Tax-loss harvesting

Harvesting tax losses to offset capital gains is sometimes held up as an effective way to minimize your tax hit.

The basic idea: Sell losing investments before year-end to reduce the tax liability on capital gains on your winning investments.

Tax-loss harvesting is most common in the fourth quarter of the year, when investors are looking for quick ways to minimize his or her tax liability to Uncle Sam.


Harvesting Risks

There’s no question that tax-loss harvesting is worth a serious look in some cases.

If you have a holding that has completely flamed out and see little chance of a comeback, this approach may have merit. However, the overall benefits of tax-loss harvesting can be overstated.

There are a number of tradeoffs and risks that may impact investors.

Here are three big ones.

1) Diversification risk

Selling a stock with a depressed value exclusively for tax reasons may not be a wise move if you believe the company has great prospects or plays a crucial role in your portfolio’s diversification strategy.

Assets that are down aren’t always a disaster.

If you believe in the company’s prospects, it might actually make sense to double down and buy more.

In other words, there’s an the opportunity cost of resigning from the field of play when a stock you wish to own is down, maybe only temporarily.

2) Backfire Risk

Sometimes investors playing the tax-harvesting game get burned.

One common strategy is to sell a holding for a tax savings advantage but then use the proceeds to buy something else that can serve as a proxy trade.

This is risky on two fronts. First, the IRS does not allow dumping a stock for tax purposes and then turning immediately around and buying it back. This is known as a wash sale.

Specifically, you can’t buy the same security (or a “substantially identical” security) for about 30 days.

If you violate this rule, you will hear from the IRS.

But let’s say you buy something else that complies with IRS rules and it takes off like a rocket.

If you choose to sell it again, you could end up with higher taxes from short-term gain of the new security than the tax savings you harvested in the first place.

3) Future Tax Risk

If you are an avid tax-loss harvester, you run the risk of inadvertently driving up your future tax rate down the road.

Let’s say you play by the rules. You harvest the tax savings from a depressed stock that you owed.

You then comply with IRS rules, wait 30 days and are lucky enough to be able to buy back your original holding at a lower price.

Brilliant, except for one thing. When you repurchase that original tax-harvested stock at a bargain, you do so at a lower cost basis (a fancy name for the purchase price) of the investment.

That lower cost basis is used to calculate your capital gain when you sell the security in the future.

Now, imagine a scenario in which you have tax-harvested and repurchased a number of your key holdings.

Then the market takes off on a multi-year joyride and you want to cash out.

Guess what? Your capital gains taxes may actually have gone up substantially, potentially eclipsing the tax savings from your earlier harvesting strategy.

Such is the double edge sword of tax-harvesting.

DISCLAIMER: The information contained in this article is general in nature and not intended as specific advice. Neither Covestor Limited nor its representatives are engaged in rendering tax, accounting or legal advice. A qualified professional should be consulted regarding the effect of such considerations on the matters covered in this article.