Tax loss harvesting is the act of selling an investment that has lost value since its initial purchase to offset other investments that have realized gains from a sale. Losses can be harvested or captured during any time of the year but it is commonly done at the end of the year.
SHORT VS LONG-TERM
When the general market or sector suffers a downturn you should consider reviewing your portfolio for any investment gains you have earned that will be taxed. Then, you can be strategic about how to keep the taxes on those gains to a minimum. First, you’ll need to know whether the gains were earned in the short-term or the long-term. Short-term gains are investments that have been bought and sold within twelve months. Those short-term gains can only be offset with short-term losses. Long-term gains are those earned from investments held longer than twelve months, and similarly, they can only be offset by long-term losses. Short-term gains are taxed at ordinary income tax rates, which is usually higher than the longer-term capital gains tax rates.
Consider selling investments at a loss when the investment sector or asset class is no longer appropriate for your investment portfolio. You can also sell investments that are at a loss for a similar security in that same asset class or sector if you wish to keep the overall asset allocation. You can use the losses in future years if you don’t have any gains to offset or if your losses exceed your current year’s gains (there are limits here so check irs.gov).
PURCHASING A REPLACEMENT
When purchasing an investment to replace the old one, you have to be careful of a wash sale. A wash sale occurs when you purchase the same or substantially identical security thirty days before or after the sale of a security. If that happens you cannot claim the loss of the sold security. A substantially identical security would be one like purchasing another ETF tracking the same exact market index. If you aren’t sure what to replace the sold security with, consider a broad market index ETF for the meantime (as long as it isn’t the same one you sold).
Remember with tax loss harvesting you don’t want to lose sight of staying fully invested for the long-term. I am not a proponent of market-timing but using a market downturn to your advantage can definitely have its rewards. Please talk to a tax advisor or financial advisor about this strategy before placing any trades in your portfolio.
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