After the bull market of 2013, there is no question that many of your clients are sitting on a pile of capital gains, and likely a hefty tax bill, come April 15. Though there are only a few trading days left this year, there is still time to lower your client’s potential tax burden by loss harvesting. But how do you explain tax-loss harvesting to clients and let them know how they can benefit?
First, explain that tax-loss harvesting is merely a technique in which capital losses are realized to offset taxable gains and potentially reduce ordinary income by $3,000 a year.
As the calendar year draws to a close, advisors should have a good sense of their client’s tax liability. If a client has significant capital gains in a mutual fund, for instance, they may want to partner with their advisor to see if there are any loss positions that can be realized to mitigate the gains. Once a weak position is sold, the proceeds are usually placed in a proxy investment that has a similar investment outlook as the original fund. After a waiting period to avoid the wash-sale rule (see below), the money in the proxy may be returned to the original investment. Loss-harvesting trades can also be done in tandem with portfolio rebalancing or raising cash, so the use of a proxy investment may not be necessary.
The client’s gains and losses are netted out and the net gain becomes the client’s new tax liability. If capital losses exceed capital gains, up to $3,000 in losses can be deducted from the client’s ordinary income for that year. If losses remain, they can be carried forward in future tax years.
Avoiding a Wash Sale
Of course, Uncle Sam is wise to methods investors employ to lower and possibly erase their tax bill, so there are some rules to follow. If loss harvesting is done while raising cash or completely rebalancing, you likely do not have to worry too much about breaking the wash-sale rules. However, if the funds raised during a rebalancing trade are to be placed in a proxy investment, it is a good idea to double check your calendar to make sure you are not violating any wash-sale rules.
A wash sale occurs when an investor buys and sells a “substantially identical” security within a 30-day window. Put simply, if a client sold Fund A on Dec. 1, invested the proceeds on the same day into Proxy Fund B, and then sold Proxy Fund B to re-enter Fund A within 30 days, a wash sale would occur and the client would be liable for the full tax burden. (Not to mention the client would likely also suffer by facing multiple transaction costs.)