Ins and Outs of Tax-Loss Harvesting

By Ellen Sheng September 17, 2020

This is Part 4 of Financial Advisor IQ’s five-part special report on how financial advisors can help their clients manage the tax impacts of their portfolios.

Tax-loss harvesting isn’t new, but robo-advisors have brought more awareness of the concept in recent years. New portfolio management tools are also helping automate the process further, making it easier for advisors to exercise ever-more-sophisticated strategies. 

While many advisors focus on tax-loss harvesting toward the end of the year, some look for opportunities to minimize tax burden throughout the year. For example, volatile markets, as seen in March and April of this year, can present a harvesting opportunity. 

“Many clients look at volatility as something unnerving,” says Jeff Coons, chief risk officer at High Probability Advisors.

But advisors can highlight ways to improve the situation by looking for tax-loss opportunities. 

“Market volatility is a powerful time to think of tax-loss selling. Everyone thinks about taxes near the end of the year,” but tax-loss harvesting “should be a regular part of the investment process,” Coons says.

Getting the full picture  

At its most basic, tax-loss harvesting gathers losses to offset capital gains, which are subject to taxes. Any leftover losses can offset up to $3,000 of ordinary income. And if there are still some losses remaining, those can be banked and carried forward indefinitely.  

To make the most of tax-loss harvesting, advisors need to understand the clients’ entire portfolio. This may require coordinating with another advisor as well as with an accountant and broker. To minimize tax impact, advisors need to know what’s happening in other parts of the portfolio, in case there are hedge funds, real estate, or other investments that affect losses and gains. 

Strategies to navigate the wash-sale rule 

A key part of tax-loss harvesting is managing the wash-sale rule. The wash-sale rule does not recognize a loss from selling a security if a “substantially identical” security is purchased 30 days before or 30 days after the sale date. This applies whether the transaction is within the same account, in different accounts or even in a spouse’s account. The rule would also apply if one stock is sold at a loss in a taxable account and repurchased in a non-taxable account, like an individual retirement account, within the restricted period. 

The most straightforward way to avoid triggering this rule is to purchase a different security or hold off on buying any securities for 31 days after a sale. But that comes with risk. 

“Most fund clients don’t want to do that,” says E. George Teixeira, tax leader of financial services practice at Anchin, an accounting and advisory firm. Clients worry that securities could increase in value during that time when they’re waiting to get back into the market. 

To get back into the market faster, there are several advanced strategies advisors can adopt.

One of the more common methods is to interpose an option — either a call option or a short in between the selling and buying. Investors can sell the security at a loss, then buy an out-of-the-money call option on the security, buy back the same or similar security and finally sell the option. The transaction can be done over three days. 

Another option is a collar involving two options: an out-of-the-money put option and an out-of-the-money call option. With this method, advisors can hedge the client’s risk but also need to be careful not to trigger a constructive sale. To avoid this, there should be a comfortable distance between the put option and call strike prices, usually between 10% to 15%. 

Still another option is a basket swap. An investor can sell a security at a loss, then go back in with a basket swap, or a basket of securities consisting of a maximum of 70% of the security sold plus 30% other securities. 

While these strategies apply to individual securities, advisors may also want to harvest tax losses from funds. Rules regarding the tax treatment of two different funds are a bit hazier. To avoid the wash-sale rule, advisors can sell a fund to realize a loss, then repurchase a fund tracking a different index but which has shown similar performance. 

Adding value 

Harvesting losses is useful as a strategy to lower or defer taxes. Losses may defer capital gains made in other parts of a portfolio. Harvesting losses also reduce short-term capital gains, which are taxed at the highest rate. In addition, they can help convert ordinary income into long-term capital gains, which are taxed at a lower rate. 

Looking at a portfolio at various points of the year and viewing it not just through the lens of returns but also the lens of tax implications helps clients make the most of their holdings. 

Next: How to Assess the Tax-Efficiency of a Fund