Now’s a Good Time to Focus on Tax-Loss Harvesting. Here Are 7 Tips.

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Given topsy-turvy investment markets, advisors and clients should revisit the strategy of tax-loss harvesting.

The option of selling securities at a loss to offset capital gains, is typically a focus at year-end. But it can be deployed at any time of year and after a large market selloff is an ideal time. While this strategy can be an effective way to minimize taxes, investors—and advisors—need to be aware of several traps that can derail the strategy, as well as best practices that can make it more effective. Here are seven tips:

Often, wash-sale issues crop up when clients have small accounts they trade on their own.

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Understand the limits. Some investors whose portfolios have been particularly hard hit may hope to reap the full advantage of those losses in a single tax year, but that may not be possible. Taxpayers whose capital losses exceed capital gains can deduct up to $3,000 ($1,500 if married but filing separately) in a given year, according to IRS rules. The remaining losses can be carried forward to future tax years until the amount is exhausted. Keep in mind that these are federal tax rules; not all states allow investors to carry forward losses, says Howard Hook, a CFP and CPA with EKS Associates in Princeton, NJ.

For tax purposes as well as from a portfolio perspective, “you don’t want an overabundance of losses,” says Bill Smith, managing director for CBIZ MHM’s national tax office. 

Beware the wash-sale rule. This rule prohibits selling an investment for a loss and purchasing the same or a “substantially identical” investment 30 days before or after the sale. “That’s the biggest trap you can fall into because you lose your loss completely,” Smith says.

There are several nuances to the wash-sale rule that tend to trip people up. One sticking point is the ambiguity of what constitutes “substantially identical.” To be safe, advisors often recommend clients err on the side of caution. So, for example, if a client owns a Vanguard S&P 500 fund, it’s not advisable to buy an iShares S&P 500 fund within 30 days, says Mark Conrad, a CPA and CFP with St. Louis-based Moneta Group. “If you’re going to sell something that’s a large-cap passive fund, I would buy something that’s more of an actively managed large-cap fund so that way you can avoid the issue,” he says.

Also be sure to time the sale so you don’t inadvertently trigger a wash sale with dividend reinvestments or capital gains distributions, he says. The rule applies to even a small reinvestment.To be safe, he advises a sale be done a full business week in advance of a dividend payout or capital gains distribution. “You really have to be cognizant of when those get paid out,” he says.

Think out of the box. Usually people think of stocks and mutual funds for tax-loss harvesting purposes, but with rates rising, some fixed-income holdings have taken a beating, creating an opportunity to harvest losses in these positions as well. “For years, this hasn’t really been an opportunity, and now it’s relevant,” says Justin Gilmartin, managing director of tax services at The Colony Group. “I think people need to be aware of it and take advantage when they can.”

Make tax-loss harvesting an ongoing priority. Especially with the market in flux, it’s a good time to look for tax-loss harvesting opportunities, says Hook of EKS Associates. Market conditions can change quickly; if you wait, or only do it at year-end, the ability to harvest losses can disappear. “Clients have to take opportunities when they can,” he says.

Have an interim strategy. Investors don’t necessarily have to remain on the sidelines during the period when the wash-sale rule applies. Clients of Kayne Anderson Rudnick Wealth Management in Los Angeles, for example, are generally invested in baskets of individual stocks. So for tax-loss harvesting purposes, the firm typically reinvests cash proceeds from a stock sale into an index fund that represents a similar asset class. This means the client is not completely out of that part of the market, says Spuds Powell, managing director. 

For instance, proceeds from the sale of a large growth stock could be used to buy an S&P 500 index fund or a large-cap growth fund for 30 days. “When corrections happen, they are good opportunities to harvest losses and reduce capital gains taxes, but they are also really good buying opportunities and it’s important that wealth advisors treat those two things in conjunction with each other as opposed to independently,” Powell says.

Once it’s safe to move ahead without violating the wash-sale rule, the fund can be sold and proceeds used to buy back the original stock. “It’s a way to maintain exposure to the markets, but the intention is to deploy the active management strategy. As soon as we can get back into the individual stocks that were sold, we do so,” he says.

Educate clients. Often, wash-sale issues crop up when clients have small accounts they trade on their own, says Moneta Group’s Conrad. They may not know about the wash-sale rule, or understand the particulars. One common mistake is to sell shares in a taxable account and buy them back in an IRA Another misstep is to repurchase the same shares, without waiting the required time period, in a spouse’s account or a business account that flows through the client’s personal return. “Advisors need to educate clients about these issues as well,” Conrad says.

Make sure the sale makes sense. Hook of EKS Associates says clients sometimes the economics don’t make sense if it means being out of the market, even for a short while.

“Sometimes the best move is not to make any move,” says Colony Group’s Gilmartin. “It’s great if you save on taxes, but if your investments are in a worse place because of it, at the end of the day, you’re in a worse position,” he says.

A related factor: Clients can sometimes get really attached to stocks and don’t want to sell, even for a short time, for tax savings purposes. It’s possible there will be a suitable replacement that doesn’t hinder the tax savings, but in some cases, clients may still not be willing to budge.

“Clients tend to be more emotionally attached to a stock than a bond,” Hook says.

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