When stocks cratered during the pandemic, some advisors aggressively booked tax losses for clients as a move in a larger portfolio chess game. “In March and April you could do incredible swaps” for clients, said V. Peter Traphagen, Jr., managing director of Traphagen CPAs & Wealth Advisors in Oradell, N.J.

The concept behind a tax swap is simple: Sell one investment at a loss in a taxable account (losses in retirement plans don’t yield a tax benefit), then reinvest in something else.

“You could be down $50,000 in a small-cap value fund, then you change to a small-cap blend fund and capture that tax loss,” Traphagen explained. This enables the client stay in the market, yet the trade creates losses that shield gains from tax while offsetting other 2020 income by up to $3,000 (for both single and joint filers), with larger losses carried forward to future years. 

“Tax-loss harvesting boosts bottom-line performance after taxes, even though it won’t show up in any performance report,” he said, adding that also provides a good opportunity to re-deploy those assets into the firm’s diversification strategy.

But there’s a hitch. Under the tax code’s wash-sale rule, the loss can’t be deducted if substantially identical securities are purchased within 30 days before or after selling at a loss.

There is no definitive IRS guidance indicating what “substantially identical” means when it comes to funds. But it is widely believed that selling one actively managed fund and buying another that has a different manager or investment objective is allowed under the law, as is selling one index fund and buying another that tracks a different index, according to Mark Luscombe, principal federal tax analyst at Wolters Kluwer Tax & Accounting, an information and software provider in Riverwoods, Ill.

Benjamin Tobias, founder of Tobias Financial Advisors in Plantation, Fla., says clients in the zero-percent capital gains bracket (joint filers with 2020 incomes up to $80,000, single filers up to $40,000) can take gains on “very low-basis positions we would like to reduce” which, without booked losses, would push the client’s income above the zero bracket and cause the gains to be taxed.

Another tax-smart strategy can involve holdings that don’t fit in with model portfolios, a situation that can occur when an advisor inherits in a new client relationship with assets that don’t fit into an advisor’s investment strategy, says Joseph Hosler, managing principal of Auour Advisory LLC, in Wenham, Mass. With losses banked, there’s no tax hit when “we take an appreciated non-core asset out of the portfolio to make the portfolio closer to what we’d like,” Hosler says.

For Diane Compardo, a partner at Moneta in St. Louis, losses reduce uncertainty in income planning. If mutual funds distribute sizable gains distributions to her clients at year end, “we have losses in place to offset those, so we have more control over the client’s gross income for the year,” she says. That makes it easier to plan around various tax-code income thresholds and means testing for Medicare premiums.

Advising clients smartly begins with appreciating the rules and their implications.

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