7 Issues That Can Complicate Tax-Loss Harvesting

Slideshow July 17, 2023 at 12:19 PM Share & Print

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Tax-loss harvesting is a solid strategy that many advisors use to help mitigate the bite that realizing capital gains can impose on clients in taxable accounts. When clients sell appreciated holdings, these gains can be offset in whole or in part by realizing losses on other holdings in the client’s portfolio.

While this can be a good way to try to minimize your client’s tax bill, like any planning strategy. tax-loss harvesting should only be done when it fits with your client’s overall investing and financial planning strategy.

Here are seven issues to consider when tax-loss harvesting for your clients.

Roger Wohlner

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1. The Wash Sale Rule

The wash sale rule states that an investor cannot purchase the same or substantially identical security as the one sold for a loss within a 61-day period of having made the sale. This includes the 30 days prior and 30 days after the sale, plus the day of the transaction. This spans not only the client’s taxable accounts but also activity in a retirement account such as an IRA.

"The same" security is fairly obvious. There are some different opinions regarding "substantially identical" securities. While there are no penalties for a disallowed tax loss via the wash sale, the loss of the tax deduction here can result in an expensive surprise for your client come tax season. Be sure to work with the appropriate experts in the firm or externally to establish guidelines regarding replacement securities and avoiding violating the wash sale rule.

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2. Identifying Replacement Securities

When selling a holding to harvest tax losses, you will generally want to purchase a replacement holding for the client’s portfolio. This can be important to maintaining the client’s target asset allocation. Again, you will need to be cognizant of the wash sale rule.

While selling and buying the exact same stock or ETF is clearly a violation, what does or doesn’t constitute a substantially similar holding can be a gray area. For example, selling the Vanguard 500 Index fund at a loss, then buying an S&P 500 fund offered by Fidelity within the period would most likely trigger the wash sale rule. Selling the S&P 500 index fund and buying a total stock market index fund probably would not trigger it.

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3. Dividend Reinvestments and Other Automated Transactions

Some clients may have dividends on mutual funds or stocks automatically reinvested in additional shares. This can be a great tool to add to their investments over time. However, when it comes to tax-loss harvesting, if a dividend reinvestment occurs on a security where some shares were sold to harvest tax losses, this purchase can inadvertently trigger a wash sale negating the ability to use those tax losses.

Analogous to this, any automated transactions such as the purchase of shares, contributions to an account or auto rebalancing can inadvertently trigger a wash-sale situation. Before executing a sale to take advantage of tax-loss harvesting, make sure that your client doesn’t have any of these automatic investing features in place on the security that is being sold.

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4. Excess Losses

Generally, it’s not a problem if a client’s tax losses exceed the amount of their realized capital gains in a given year. Up to $3,000 of additional tax losses can be used to offset other income in that same calendar year. Excess realized losses can be carried over for use in subsequent years, but only to offset future capital gains.

This may be fine if the amount of these losses is not so large that your client won’t be able to use them up in a reasonable amount of time. But in cases where the harvested losses are quite substantial or where the client may not be realizing significant gains in the future, these accumulated tax losses may not be useful to your client. Additionally, carried-over tax losses will expire upon your client’s death; they cannot be passed on to their heirs.

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5. Tax Deferral vs. Tax Savings

In some cases, investors will sell an investment and harvest the tax loss. They will then buy a replacement holding, conceivably at a favorable price. If the replacement investment appreciates to a point where the gain on that investment is similar to the amount of the loss your client was able to deduct, and if they are in a similar tax bracket, the value of the tax deduction and the gain on the new investment will essentially cancel each other out.

While there is a time-value-of-money benefit in this type of situation, the amount of the actual tax benefit between the two holdings is often minimal. In a situation where your client’s time horizon to hold the replacement investment is relatively short, you will need to analyze if tax-loss harvesting is worth it for them.

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6. Other Tax Planning Goals

Tax-loss harvesting may complement other tax planning goals for your client. One example might be for clients who are on Medicare and/or Social Security. One issue for clients on Medicare is triggering future IRMAA surcharges based on their income. If there is a year with high realized capital gains, using tax-loss harvesting can help offset those gains and help avoid the surcharge two years down the road.

With Social Security, using tax-loss harvesting to offset capital gains can help reduce a client’s potential tax hit on their Social Security benefits for that year.

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7. Tax-Gain Harvesting

Instead of or in conjunction with tax-loss harvesting, tax-gain harvesting might be an appropriate strategy. If your client finds themselves in a low tax bracket this year, harvesting long-term gains can make sense as part of their portfolio rebalancing. Also, as long as there is no associated tax-loss offset, they can repurchase the security at a higher cost basis, reducing future capital gains taxes.

Tax-gain harvesting can also be a good strategy if your client has a large amount of tax losses that have been carried over from prior years that need to be used. As with any strategy, this is only a good idea if it makes good investing sense for them.

Tax-gain harvesting can also be a way to reduce a concentrated position within the portfolio. Longtime holders of stocks like Apple or other tech names might find themselves in this position, as well as clients with a concentrated position in their employer’s shares.

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