It’s the holiday season! Time to hit those door busters, make sure every light twinkles, and check those lists twice.
Of course, sadly, once childhood passes, those lists include things both dear and not so dear, like tax planning.
Gather ye turkey whilst ye may, for tax season is neigh upon us! Time to figure those RMDs, consider ROTH conversions, prepare for the onslaught of 1099-type documents next year, and knuckle down to do some capital gains tax management.
For now, let’s focus on managing your capital gains using tax-loss harvesting. As most of you know, gains on stocks are taxable, but any losses reduce the net gain, sometimes to even zero or less.
This can save a lot of tax.
Of course, most folks are reluctant to take losses. Besides the emotional gut punch, just because a stock is at a loss doesn’t mean it should be sold. We’ve made a lot of money over the years hanging on to stocks that were down but eventually went way up.
By the same token, folks are often reluctant to sells stocks they should, like because the stock’s overvalued or they own too much of it to be safe. But they hate to pay the tax, and so hold on anyway.
If you feel like you’re in this boat, here’s some year-end tax cheer. Followed carefully, it can eliminate some taxes forever – yea, I said forever – without materially changing your investment position or market exposure.
The basic premise, of course, is to sell “losers” and “winners” during the same year, working it out to no net gain.
When I say winners or losers, I refer exclusivity to whether there is a tax gain or loss, not to investment merits.
This lets you lock in gains tax free by netting against losses.
For instance, you are up $100,000 in stock A, and down $110,000 in stock B. Sell them both and that works out to a capital loss of $10,000, which you can use against something else or save for later (after taking the net allowed capital loss of $3,000 against other income.)
Of course, the price of the strategy is selling stocks you really may not want to sell. And you just can’t book the tax transactions and rebuy the stocks the next day, since the IRS wash sale rules you stay out at least 30 days or the tax treatment is nullified. 30 days is deemed long enough that more could change than investors would want to risk by staying out.
Of course, as with most things tax, careful planning reveals opportunities to have your tax cake, but eat it too.
About 20 years ago, I coined a term called the Dry-Cleaned Wash Sale to describe the method.
Here’s how it works.
Say you have XYZ at a big gain but really like it. You have something you can sell for an offsetting loss, but don’t what to stay out of XYZ for 30 days. The key is to find something that will give you very close exposure to XYZ without being what the IRS calls a “Substantially Identical Security.” For instance, selling Berkshire A and buying Berkshire B won’t work.
But selling Shell and buying Exxon would. Since these two track each other fairly well, it maintains investment exposure.
This is even easier to do with mutual funds and ETFs.
Investopedia uses the example that if an investors sells “SPDR S&P 500 ETF (SPY) at a loss, they can immediately turn around and purchase the Vanguard S&P 500 ETF… (as) the two S&P 500 ETFs have different fund managers, different expense ratios, may replicate the underlying index using a different methodology, and may have different levels of liquidity in the market. Presently, the IRS does not deem this type of transaction as involving substantially identical securities and so it is allowed.”
If you liked what you sold to get an offset loss, you can use the same method to get a placeholder replacement investment.
As a practical matter, you keep essentially identical exposure in case the market goes way up, but you rachet up your tax basis. This process converts otherwise taxable gains into tax free gains.
After waiting the required 30 days, just swap back into what you really want.
And that’s pretty cool, even in winter!