It’s that time of year again—tax-loss-harvesting season. When financial advisors have a chance to help clients clean up their investment portfolios while reducing the tax bite.
Here you can reduce an investor’s tax liability by selling investments that have suffered losses, and in turn those losses will offset any capital gains your client might have from other investments. For instance, if the client’s $5,000 realized capital gain is paired with $3,000 in losses, you would reduce their tax liability to just $2,000.
If a client’s losses exceed their capital gains, they can use up to $3,000 (or $1,500 if married filing separately) of the excess loss to offset other income, such as wages or salaries. Any remaining losses can be carried forward to future tax years.
This year has been more challenging for tax losses, however. After the widespread gains in major stock market indexes, along with the advances in most industry sectors, it’s been harder to find losers.
“Tax-loss-harvesting has become more and more difficult over the last few years,” said Shana Orczyk Sissel, CEO of Banríon Capital Management. “While there have certainly been losers in equities [such as small caps], the vast majority of investors have focused on winners.”
Sissel said advisors should be mindful to expand their investments—by looking into alternatives, for instance—to find more tax-loss opportunities.
Take oil and gas. The IRS allows investors to write off almost 100% of the investments in these commodities against taxable earned income, whereas you can write off only a small portion of most equities. The tax rules are constantly changing, so advisors need to stay on top of any laws that could affect their clients.
As advisors do year-end investment planning, exchange-traded funds will make it easier for them to maintain a client’s overall market exposure even as they are selling positions to harvest losses. Such vehicles offer clients portfolio continuity without requiring advisors to make major changes to the clients’ asset mixes.
Since there are so many ETFs available, clients can sell one ETF to realize a tax loss and then immediately purchase another with a similar strategy to maintain the position—though the position can’t be identical, since clients will want to avoid running afoul of the IRS’s wash-sale rule.
Tax avoidance is another strategy that could have appeal for investors sitting on hefty long-term gains. Instead of taking huge hits, they can keep their winners while still protecting some or all of their built-up gains.
One strategy is to use inverse single-stock ETFs.
Take the story of the orthodontist in The Wall Street Journal who built up a $15 million position over the years in Nvidia stock when his original basis was $100,000. Here, the Direxion Daily NVDA Bear 1X Shares fund (whose ticker is “NVDD”) could be used to protect some or all of an investor’s unrealized gains in the stock. Since the Direxion fund is designed to deliver 100% of the daily opposite performance of Nvidia, any decline in the stock would be offset by a gain in the Direxion fund.
“Our suite of leveraged and inverse single-stock ETFs has become very popular,” said Ed Egilinsky, the head of product at Direxion. “We have the Magnificent 7, and that franchise is a little over $3 billion in assets.”
Whether it’s tax avoidance or tax-loss harvesting, there are plenty of opportunities for advisors to help clients reduce the bite of taxes.
Ron DeLegge II is the founder of ETFguide.com and author of several books, including Habits of the Investing Greats and Portfolio Architecture: A Handbook for Investors.