What is Tax-Loss Selling?
Taxes were recently due, and you may still be reeling from the sting of paying heavily due to significant capital gains.
The memory of all the taxes you just paid, coupled with a volatile stock market, may make this the right time to consider tax-loss selling.
Tax-loss selling involves selling investments in taxable brokerage accounts at a loss to reduce capital gains tax. Since a capital loss is tax-deductible, the loss can be used to offset any capital gains to reduce your tax liability. If the losses exceed the gains in a current year, up to $3,000 of the amount that exceeds the gains can be deducted against ordinary income. Any amounts over and above can be carried forward to a future year.
How Tax-Loss Selling Benefits Investors
As advisors, we look for opportunities to do this for clients annually. However, for many clients, years and years of strong stock market performance resulted in few, if any, unrealized losses in their portfolios.
Several new opportunities have recently presented themselves. Clients in several situations may have losses, which can be realized and utilized against current and future gains. Consider the following:
- Interest rates have risen this year, resulting in a decline in the price of bonds. As of the end of April, the aggregate bond market was down 9.4%. This creates an opportunity for those holding bond funds to realize losses.
- Clients who reinvested their capital gain distributions from mutual funds in the last quarter of 2021 may want to sell those specific shares if the current share price is lower than what it was when the shares were reinvested. By doing so, they could realize a short-term taxable loss.
Things to be Aware of When Tax-Loss Selling
However, there are several things you need to be aware of when considering tax-loss selling. For example, long-term capital gains are taxed at a lower favorable rate than short-term capital gains for investments held for more than a year. While Uncle Sam taxes short-term capital gains at the same rate as federal income taxes – which can be as much as 37 percent – the highest long-term capital gains tax rate is 20 percent. Depending on your income and filing status, it can be as low as zero percent.
There is also a “wash share rule” when you sell a security at a loss and then purchase a “substantially identical” security within 30 days. In this case, you cannot realize the loss from the sale. The loss is deferred until you sell the shares you bought within 30 days of the sale.
There are other tax traps to consider that can prevent you from maximizing your losses, so care is needed when implementing any strategy.
Contrary to popular belief, tax-loss selling is not only something to consider as part of your tax planning at the end of a calendar year. Now is the time. If the markets turn around, it may be too late. Talk to your advisor to see if this can work for you.