Proposed tax increases on the wealthy being discussed in Washington, D.C., mean that many tax-saving tactics are on the table with advisors and their clients. One of these tools is tax-loss harvesting, which involves selling a capital asset that’s lost value and replacing it with a similar investment.
“If the overall loss exceeds the gains from a portfolio, the loss can be carried over,” said Brent Lipschultz, partner in EisnerAmper LLP’s personal wealth advisor practice.
Biden tax changes make this a good strategy now, long before the end of the year. “A long-term capital gains rate of 43% practically doubles the tax impact from current levels,” said Gregg Coury, CEO The Coury Firm in Pittsburgh. “By realizing gains under the current tax regime, [wealthy] clients should save significant tax dollars.”
Loss harvesting can also be used throughout the year. “Annually, advisors and investment managers face a deluge of tax harvest requests at the end of the year from clients looking to reduce their taxes,” said Mark Peabody, senior vice president for product management at Vestmark in Wakefield, Mass. “More portfolio managers are implementing opportunistic harvesting strategies throughout the year.”
An example of loss harvesting that could be used for the rest of 2021 would be to design a portfolio to replicate a particular stock index, such as the Standard & Poor’s. “If a stock holding in that index fell below its cost, the client or the portfolio manager would sell the stock and replace it with another security in the same industry segment that may have greater appreciation potential,” Lipschultz said.
Frank Pape, senior director of portfolio consulting for Russell Investments in Seattle, added, “Assuming the advisor has the operational infrastructure in place, if a security or sector—think energy in the first quarter of 2020—pulls back in value and if the market value is less than the investor’s cost basis, one could sell the selected names with the market value less than the cost basis. This transaction creates a realized loss, a tax asset [to] neutralize the realized gain and not pay taxes. If the realized losses are greater than the realized gains, the loss can be carried forward into 2022 and beyond. If tax rates go up, this loss carry-forward is even more valuable.”
Several elements are vital for year-long tax harvesting, including technology to spot harvesting opportunities, avoiding wash sales and minimizing tracking errors, Peabody said.
Where should advisors redeploy the capital? “Valuations are high and with the threat of higher taxes and rising interest rates, we must be diligent in how capital is redeployed,” Coury said. “The risk-reward profile has certainly changed.”
Tax-managed equity funds, which focus on minimizing returns lost to taxes, have demonstrated compelling after-tax returns and lower tax drag than the average active mutual, index or exchange-traded fund, Pape said.
Thirty days have to pass before repurchasing the same security after the original security has been sold at a loss under "wash sale" rules. “Sometimes selling stock at a gain rather than a loss may be beneficial if there’s no capital gains,” Lipschultz said. “You could repurchase the stock immediately as the wash sale rules don’t apply on a stock gain."
Be careful in strategically using the losses in a way that is most tax-advantaged, advisors said. “If an individual sold stock on a short-term basis—a holding period for less than one year—and used that loss to offset long-term capital gain property, taxed at lower capital gains rate, this isn’t the most efficient utilization of the capital loss,” Lipschultz said, adding that the potential costs of loss harvesting include commissions, especially if the securities sold are not in a managed portfolio.
One of the biggest obstacles to this strategy might be client perceptions. “Investors don’t like hearing they’ve lost money, and the term ‘loss-harvesting' requires them to acknowledge an investment loss,” Pape said.
“Clients may be gun shy when it comes to harvesting a loss on an investment, hoping it will go back up and fearing they will miss out on the recovery,” Coury added.