Tax-loss harvesting is a strategy involving the selling of securities at a loss to offset the amount of capital gains when other securities are sold at a profit. The tax benefits from this strategy not only include taxes saved from offsetting gains and losses; if capital losses exceed capital gains in a given year, the investor can offset up to $3,000 of that loss against current income. Any additional losses that can’t be used during the current year may be carried forward indefinitely until the loss is exhausted, providing a maximum offset of $3,000 to income for each year in the future. This is a valuable tool for many investors who are seeking to reduce their overall taxes particularly when market pricing has declined. However, the strategy must be utilized with caution.
As with anything involving taxes, the rules and regulations around tax-loss harvesting are strict and complex. After the security is identified and sold at a loss, the IRS requires that the investor wait at least 30 days before purchasing the same security or a “substantially identical” security to claim the loss. Substantially identical securities can include securities issued by the same or different corporations. This is called the “wash sale” rule as defined by the IRS. If the goal is to remain invested for 30 days in case markets rebound, investors can navigate around the wash sale rule by swapping the security for another that is similar but not substantially identical.
For example, Harbor models hold a position in JPMorgan’s Small Cap Equity Fund (VSEIX), which is an actively managed mutual fund seeking to invest in a diversified portfolio of small cap stocks with similar market capitalizations to the Russell 2000 index. Due to a volatile start to the year, many clients had a loss on their position. To harvest this loss, we sold this fund and purchased the SPDR S&P 600 Small Cap ETF (SLY). SLY is a passively managed fund that, as the name suggests, tracks the S&P 600 Small Cap index. The key differences in the management of each fund allows for this swap to occur. By purchasing SLY as a substitute, we maintained our small cap exposure, while also booking capital losses. We then held SLY for 30 days to comply with the IRS’s wash sale restrictions. Once the wash sale period ended, we sold SLY and re-purchased our model position VSEIX. In this scenario, we were able to “harvest” the losses from JPMorgan’s Small Cap Equity Fund (VSEIX) and maintain similar exposure in the overall portfolio by purchasing the SPDR Small Cap Equity ETF (SLY).
This strategy does not come without risks. In the scenario outlined above, there is always the possibility that SLY will experience a price increase during the 30-day window. Should this happen, the investor would want to review if the gain on SLY is more or less than the loss booked on VSEIX. If the gain on SLY is more, the investor should consider if it is advantageous to book a short-term gain by selling SLY and rebuying VSEIX at the preferred allocation in the model. The investor should be aware that tax-loss harvesting on a highly volatile security may be ineffective if the gain on the new security exceeds the loss on the original security after the 30-day wash sale window.
The suitability of the replacement security is also a major factor when an investor is seeking to book capital losses. For some highly specific positions, such as some of our target sector funds, a suitable alternative isn’t available. In other words, a fund can be so unique that a highly correlated replacement fund cannot be found. Attempting to capture losses on these funds would undermine our ability to maintain our targeted exposure. There are a number of funds for which a satisfactory replacement fund exists, such as funds that track major indexes.
Tax-loss harvesting can be an effective strategy to lower taxes when implemented properly. It is an active management strategy that can be time consuming and complex, but it can be worthwhile to the investor. Here at Harbor, we monitor our portfolios throughout the year to identify tax-loss harvesting opportunities and execute when it is appropriate. This becomes even more important during periods of market volatility as we have experienced so far this year. For more information and questions about tax-loss harvesting, or your specific situation, please contact us or your accountant.
~Griffin Young