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Financial Planning > Tax Planning > Tax Loss Harvesting

Last-Minute Tax Loss Harvesting Tips for 2021

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What You Need to Know

  • Advisors should pay particular attention to clients who may have engaged in cryptocurrency trading during the year.
  • Clients should be careful when selling an investment merely to offset capital gains.
  • Clients should watch out for wash sale issues if they want to reinvest the proceeds quickly.

The equity markets have performed extremely well for many clients in 2021 — in some cases, the gains may have been surprising enough to motivate the client to cash out on investments at a significant gain without much planning or advice.

While that can be considered a positive development for many, it can also mean that many clients may be faced with a larger-than-anticipated year-end tax bill on unexpected capital gains. Clients have a few short days to take action to prevent a surprise tax hit from digging into their profits.

While tax loss harvesting strategies are old hat for many advisors and clients, implementing these strategies properly can gain new importance for clients who may have unexpected gains for 2021—and advisors should pay particular attention to clients who may have engaged in cryptocurrency trading during the year.

Capital Gains Taxes: The Basics

Many clients are familiar with experiencing a year-end capital gains tax bill. They’ve even come to expect it. However, 2021 was unique for a number of reasons — meaning that some clients could be faced with long-term capital gains tax liability for the first time ever.

Fluctuations in the cryptocurrency markets during the year may have prompted many investors to sell when cryptocurrency prices were at their peak. Because cryptocurrency is treated as property, those clients will be liable for capital gains taxes on their profits — and it’s no longer possible for those clients to fly under the IRS’s radar when it comes to reporting crypto gains.

Remember, tax loss harvesting strategies don’t apply to traditional retirement accounts, like IRAs or 401(k)s, where the funds grow on a tax-deferred basis. Those distributions are subject to ordinary income tax upon withdrawal, not capital gains taxes.

Further, clients should remember the distinction between short-term and long-term capital gains. Long-term capital gains tax rates apply when the client has held the asset for one year or more. Long-term capital losses will offset long-term capital gains.

If the holding period is shorter, the rates will be taxed as short-term capital gains (which mirror ordinary income tax rates).

Tax Loss Harvesting Strategy

First and foremost, any tax loss harvesting strategy must be executed by Dec. 31 in order for the loss to offset 2021 gains. With the tax loss harvesting strategy, clients will want to pay attention to fluctuations in asset value. Selling a capital asset at a loss in a year when the client will also realize long-term capital gains can offset the capital gains tax liability.

To execute a tax loss harvesting strategy, clients simply sell capital assets that have fallen in value to offset their capital gains for the year. These clients should also note that they can use up to $3,000 in capital losses to offset ordinary income for the year.

Further, any disallowed capital losses can be carried forward to future years if they exceed the client’s capital gains by more than $3,000.

As always, clients should be careful when selling an investment merely to offset capital gains. Some investments may make sense in the long term even if they’ve performed poorly in recent years. Those long-term payoffs are also an important issue when considering the client’s long-term tax outlook.

More on this topic

Clients should also be advised to watch out for wash sale issues if they want to reinvest the proceeds quickly. The IRS can disallow a client’s capital loss if the client reinvests the sale proceeds in substantially similar assets within 30 days after the initial sale.

Notably, the client doesn’t have to invest in the exact same type of security or asset to become subject to the wash sale rules. If the assets are deemed to be substantially similar, the wash sale rules can apply to disallow the loss — and there’s no precise definition of “substantially similar,” making professional advice critical to avoid losing the benefit of a capital loss. 

Instead, many clients who don’t want to wait 31 days to reinvest may wish to consider reinvesting the proceeds in an ETF or a mutual fund in order to maintain a similar asset allocation without running afoul of IRS rules.

Importantly, clients should also be advised that the latest version of Biden’s social spending bill could apply the wash sale rules to cryptocurrency transactions.

Special Considerations for 2021

The year 2021 has been one of uncertainty on many fronts. Twice Congress introduced legislation that would have applied long-term capital gains rate increases retroactively to the date the legislation was first introduced. Those capital gains tax increases haven’t become law.

That doesn’t mean the picture won’t change in 2022. Clients who are interested in executing a tax loss harvesting strategy should also be advised to keep an eye on the future. It’s possible that, if capital gains rates go up next year, those poorly performing assets could become even more valuable in 2022.

Conclusion

It’s impossible to know what the future holds when it comes to proposed capital gains tax rate hikes. For many clients, the smart move may be to execute a sale now to offset current capital gains tax liability. Others may be better off paying capital gains tax at today’s relatively low rates and waiting until next year to execute a tax loss harvesting strategy.

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For previous coverage of tax strategies for appreciated assets, see Advisor’s Journal. For in-depth analysis of the long-term capital gains tax rules, see Advisor’s Main Library.

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