The economics of tax-loss harvesting

Tax-loss harvesting is a popular investment strategy that seeks to obtain a tax benefit from the sale of securities that have declined in value. It is an intricate, nuanced strategy that may provide tremendous tax benefits to some investors but is not appropriate in all situations. Understanding the context and mechanics of loss harvesting can help advisers identify suitable candidates and circumstances for its use.

Why harvest losses?

U.S. federal income tax law allows capital losses to offset capital gains and limited amounts of ordinary income that would otherwise be taxable to investors. Consequently, the methodical realization of capital losses by selling securities that have declined in value has become a tax management staple for many investors. The goal of tax-loss harvesting is not to invest in securities that will decline in value but rather to improve after-tax returns by taking advantage of market volatility.

Which investors stand to benefit from tax-loss harvesting?

For tax-loss harvesting to be beneficial, it must be effectuated in taxable accounts, and investors must have sufficient capital gains or other income available to absorb the realized losses. Capital losses may offset capital gains and up to $3,000 of ordinary income on the federal income tax return of a noncorporate taxpayer.¹ For assets held directly as individual securities in separately managed accounts or in flowthrough entities such as investment partnerships (e.g., private equity or hedge funds), both short- and long-term capital gains pass through to the investor’s Schedule D, Capital Gains and Losses, where they can potentially be offset by capital losses from loss harvesting.

In contrast, not all capital gains distributed by open-end mutual funds, exchange-traded funds (ETFs), and other funds governed by the Investment Company Act of 1940 (’40 Act funds) flow to an investor’s Schedule D. Long-term capital gain distributions maintain their character and flow to an investor’s Schedule D; however, short-term capital gain distributions from ’40 Act funds are treated as nonqualified dividend income to investors and thus are ineligible to be offset by capital losses on Schedule D.

Tax-loss harvesting as a specific strategy is typically offered through a separately managed account. While losses realized in ’40 Act funds cannot be passed through to investors, losses harvested within separately managed accounts can flow through to investors and be used to offset capital gains generated from outside sources. Losses realized within certain flowthrough or disregarded entities, such as partnerships, S corporations, or certain trusts, may provide a similar benefit to the owners of these entities.

Some investors generally should avoid harvesting losses, including tax-exempt investors, investors with only tax-advantaged accounts (i.e., individual retirement arrangements (IRAs), health savings accounts, Sec. 529 plans, Sec. 401(k) plans, etc.), and investors without adequate capital gains or other income available to offset the losses. In certain situations, it may be beneficial for an investor to realize long-term capital gains rather than harvest losses. For example, realizing gains may be appropriate to achieve tax bracket management objectives, to manage risk, or to absorb expiring net operating losses.

Tax-loss harvesting reduces the basis of a portfolio

Financial literature tends to focus on the immediate tax savings from tax-loss harvesting but frequently neglects to consider its impact on the cost basis of the investment portfolio. While loss harvesting can provide valuable upfront tax savings, the cost basis of the portfolio is reduced over time by the amount of the realized losses. In other words, higher-basis tax lots are replaced with lower-basis tax lots, potentially causing offsetting capital gains to be realized in the event of a future liquidation.

Example: Consider a hypothetical investor who purchases security A for $10,000 and harvests a $3,000 loss when the price of the security declines to $7,000. The investor immediately reinvests the proceeds in security B, which is not substantially identical to security A but has similar risk and return characteristics (and for simplicity, assume future investment performance is identical for both securities in this example). The investor later sells security B after the price of the security increases to $10,000, realizing a $3,000 gain.

Had the investor not harvested the $3,000 loss, no capital gains would have been realized at final liquidation. In either scenario, capital gains and losses net to zero.

Sources of value of tax-loss harvesting

From the simplistic example above, it might appear that tax-loss harvesting does not add any value, since the capital gains realized at liquidation appear to negate any perceived tax benefits procured from the previously harvested losses. However, such a conclusion ignores three types of benefit:

• Permanent reduction of current tax liability;
• Tax-rate arbitrage; and
• Tax deferral.

Permanent reduction of current tax liability

Capital losses generate upfront tax savings as they offset capital gains that would otherwise be taxable.² Although tax-loss harvesting reduces the cost basis of an investment, lower basis does not always result in additional capital gains taxes in the future.

For example, donating long-term appreciated securities to charity may provide donors with a fair market value (FMV) charitable deduction and avoid realization of the embedded capital gains.³ Alternatively, passing appreciated investments through an estate generally provides heirs with a cost basis that is stepped up to the FMV of the securities.⁴

In such cases, the current tax benefits from harvested losses never diminish upon future disposition.

Tax-rate arbitrage

A second potential benefit of tax-loss harvesting is that an investor may profit from any favorable tax-rate differential between the benefit of the harvested losses and the cost of the realized gains.

For example, at liquidation, securities held for longer than a year are generally taxed at preferential long-term capital gains tax rates for federal tax purposes.⁵ However, if an investor has short-term capital gains available to offset, then harvested losses may net against capital gains otherwise taxable at higher ordinary-income tax rates.⁶ Even if an investor has no short-term capital gains, excess capital losses may offset limited quantities of ordinary income each year.

Some investors with only long-term capital gains available to offset might also benefit from advantageous differences in their long-term capital gains marginal tax rates. For example, some investors may be subject to higher marginal tax rates during their working years than in retirement. For such investors, losses harvested during their working years may offset long-term capital gains taxable at a 23. 8% or 18.8% federal tax rate, while long-term capital gains realized during retirement may be taxed at a lower 15% or even 0% federal tax rate.⁷

Similarly, investors with only long-term capital gains available to offset may benefit from a favorable tax rate difference if they move to a lower-tax jurisdiction, future legislation lowers long-term capital gains tax rates, or the appreciated securities are gifted to a lower-bracket taxpayer prior to liquidation.

Of course, disparities in tax rates can also be unfavorable for an investor. A tax rate increase due to a life event, change in tax policy, or a realization event, such as a Roth IRA conversion or asset sale, could result in a negative tax-rate differential.⁸

Tax deferral

Even if a tax-loss harvesting portfolio will eventually be liquidated and additional capital gains realized because of the reduction in cost basis, substantial time may separate when capital losses are harvested from when capital gains are realized at liquidation, which is a third benefit of the strategy.

Any initial tax savings from harvesting capital losses can be reinvested and may compound over time. Alternatively, the tax savings can be used to pay down debt and thus reduce interest expenses over time. The investor may retain any income or growth generated from the original tax savings, net of taxes, even if some or all the upfront tax savings are later diminished by capital gains taxes at liquidation.

In a sense, investors are receiving an interest-free loan from the government that can be invested over the term of the loan. At future liquidation, the original “loan principal” (the initial tax savings from loss harvesting) may need to be paid back, but any investment earnings, net of taxes, may be retained by investors.

Investments that will be donated to charity or passed through an estate retain both the current tax savings as well as any growth from reinvestment.

Portfolios with a positive tax-rate differential may retain a portion of the initial tax savings in addition to any after-tax investment earnings derived from reinvesting the upfront tax savings.

Of course, investors must invest (or pay off debt), rather than spend, the initial tax savings to obtain any tax deferral benefits, and any investment losses would be borne by the investor.

The tax-loss harvesting life cycle of a diversified equity portfolio

In a cash-funded diversified equity portfolio, opportunities to harvest losses are typically more plentiful in the earlier years of a tax-loss harvesting strategy while the cost basis is high relative to the value of the portfolio. However, as the value of the portfolio appreciates and the cost basis trends downward over time, opportunities for loss harvesting may decline.

The current tax savings tend to be greatest in the early years of the strategy and over shorter investment horizons may contribute the majority of the overall loss harvesting benefits. Tax deferral benefits, on the other hand, are more likely to accrue over time and may supply most of the value from loss harvesting over longer investment horizons, after a portfolio may not be generating much in terms of new losses.

Some critics of tax-loss harvesting focus solely on the tendency for the upfront tax savings to diminish over time while ignoring the tax deferral benefits, which tend to accumulate as a strategy ages.⁹

Factors affecting the benefits from a tax-loss harvesting strategy

The total benefits derived from a tax-loss harvesting strategy is a function of both the quantity of losses harvested and the value of those harvested losses.

Factors affecting the quantity of harvested losses

For investors who benefit from loss harvesting, having additional opportunities to harvest losses may increase after-tax returns. Summarized below are some of the elements that influence an investor’s ability to harvest losses and, thus, the quantity of losses that can be harvested.

Account funding: Accounts funded with cash may have a higher cost basis and more loss harvesting opportunities than accounts funded with highly appreciated legacy securities.

Size and frequency of cash infusions and withdrawals: Contributions of cash increase the overall cost basis of a portfolio and may facilitate additional loss harvesting opportunities. Reinvesting cash from dividends and other corporate actions provides a similar benefit. Account withdrawals and dividend sweeps (where dividends are not reinvested in the portfolio) may decrease the basis of the portfolio and curtail future loss harvesting opportunities.

Timing and frequency of tax-loss harvesting: Investors who consistently and systematically harvest losses throughout the year may experience increased opportunities for loss harvesting relative to those who only harvest losses available at year end. Unrealized losses may dissipate if not harvested in a timely manner.

Market environment: Opportunities for loss harvesting tend to be most plentiful in downward-trending or turbulent markets.

Size and frequency of charitable donations: Donating the most highly appreciated securities to charity and then replenishing the account with cash increases the cost basis of the portfolio and may enable additional loss-harvesting opportunities.

Risk characteristics of underlying investments: Opportunities for loss harvesting may increase significantly when investment returns are more volatile and widely distributed (i.e., high dispersion). For this reason, individual stocks may present greater opportunities for loss harvesting than bonds, equity ETFs, or equity mutual funds (see the chart “Tax-Loss Harvesting Potential for Investments Compared,” below).

With a mutual fund or ETF, an investor may harvest losses only if the single pooled investment vehicle has an embedded loss. In contrast, in a direct indexing portfolio, which holds many of the underlying securities comprising an index, there may be dozens or even hundreds of opportunities to harvest losses, even if the overall index is trending upward. The Russell 3000 Index, for example, had stocks with negative returns every year from 1998 to 2021.¹⁰

Factors impacting the value of harvested losses

When losses are harvested, certain elements affect the value of the losses to investors, including:

Character of capital gains and losses: Investors with short-term capital gains available to offset (which generally excludes short-term capital gain distributions from mutual funds, which are treated as nonqualified dividends) may benefit more from tax-loss harvesting than those with only long-term capital gains. Harvesting a capital loss before it becomes long-term in nature may increase the value of the loss.¹¹ Marginal tax rates: Investors with high marginal tax rates may extract more value from harvested losses than investors subject to lower tax rates.

Future disposition: Investors who will donate securities to charity or pass them through an estate may benefit more from loss harvesting than those who will liquidate their securities.

Investment horizon: Opportunities for loss harvesting tend to decline over time. However, investors with longer investment horizons may accumulate greater tax deferral benefits.

Market environment: The value of tax deferral tends to be greatest in upward-trending market regimes.

Character of dividends: Loss harvesting involves trading, which affects the holding period of securities in a portfolio. For a dividend to be treated as qualified, the stock must be held at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.¹²

Tax-loss harvesting trade-offs

The costs and risks of tax-loss harvesting render it inappropriate for some investors. There are trade-offs involved, as can be seen by considering the effect of the wash-sale rules. These rules exist to delay the recognition of capital losses if no substantive change in investment position occurs. A wash sale is defined as selling securities at a loss and then purchasing substantially identical securities within 30 days before or 30 days after the sale (Sec. 1091) .

Loss harvesting is often implemented in a strategy that tracks a benchmark (aims to deliver benchmark-like returns). To avoid a wash sale when harvesting a loss, investors may immediately reinvest the sales proceeds in a security or basket of securities that has similar risk and return characteristics as the original security (to maintain the desired portfolio risk characteristics) but is not substantially identical for wash-sale purposes.¹³ Index-tracking loss-harvesting investors generally do not fully replicate an index, in order to ensure a supply of available replacement securities that will not trigger wash sales.

The action of loss harvesting creates risk by generating deviations from the benchmark. Investors may experience differences in returns between a portfolio and its benchmark, known as tracking error, which can erode any benefits from loss harvesting. To manage this risk during the rebalancing process, managers may use risk models that aim to control any portfolio tracking error. Deviations in portfolio risk and returns relative to the benchmark may be modest when a loss harvesting strategy is implemented well.

Other potential loss harvesting trade-offs may include increased transaction costs and management fees, the risk of tax rates increasing, and the potential loss of qualified dividend treatment. For loss harvesting to be advantageous, the expected benefits should exceed all anticipated costs.¹⁴

Behavioral finance considerations

Despite the potential benefits, some investors may not take advantage of tax-loss harvesting for emotional reasons. For example, instead of viewing a realized loss as a tax asset or silver lining, some may view harvesting a loss as evidence of a bad investment and may elect not to realize the loss in the hopes that the original investment will rebound. In this narrow situation, more automated trading systems may offer advantages over humans, in that computer algorithms do not feel remorse or shame for having bought an asset that declined in value, thus avoiding behavioral bias that can harm returns.

A word of caution on advertised benefits

Tax-loss harvesting can be a powerful strategy for many investors. However, when trying to estimate the suitability and potential advantages of a loss harvesting strategy, investors and advisers should make reasonable assumptions and be wary of marketing materials touting sensational benefits.

Such materials or studies may be cherry-picking only favorable assumptions, even if such assumptions apply to only a small minority of investors and grossly overstate the estimated benefits of loss harvesting for most investors.

The most recent IRS tax return data indicates that more than 90% of individual filers did not recognize any net capital gains for tax year 2020. For such individuals, the value of loss harvesting may be limited compared to taxpayers with capital gains available to offset. The IRS data also indicates that only about 5% of individual taxpayers recognized net short-term capital gains.¹⁵ Such statistics may not stop advertisers who benefit financially when investors are unaware of such details.

A powerful tool, with trade-offs

Tax-loss harvesting can be a powerful mechanism to reduce an investor’s overall tax burden and improve after-tax returns. However, loss harvesting involves trade-offs, and the strategy is not appropriate in every situation. Many factors affect the economics of loss harvesting, and the actual benefits derived will vary based on the facts and circumstances of the investor and general market conditions. Advisers can assist clients in navigating these complex considerations.

The information contained herein is provided with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in these areas. None of the examples should be considered advice tailored to the needs of any specific investor or a recommendation to buy or sell any securities. Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal, or volatility of returns.

Footnotes

¹The $3,000 threshold is reduced to $1,500 in the case of a married individual filing a separate tax return. For corporations, capital losses may only offset capital gains (see Sec. 1211).

²Excess capital losses may be carried forward indefinitely during a noncorporate taxpayer’s lifetime (Sec. 1212(b)) and used to offset capital gains in future tax years. Capital losses retain their character (short-term versus long-term) as they carry forward to future tax years. Upon termination of a nongrantor trust, any capital loss carryovers transfer to the beneficiaries succeeding to the trust property. A corporation may carry capital losses back three tax years and then forward for five years. Some states may not permit capital losses to carry forward. (See Fleming, “Too Much of a Good Thing? Planning for Capital Loss Carryovers,” Tax Notes Federal (July 2022).)

³For donations of appreciated long-term capital gain property to a public charity, the charitable income tax deduction is generally limited to 30% of adjusted gross income (Sec. 170(b)(1)(C)).

⁴Sec. 1014.

⁵Sec. 1(h). Many states tax all sources of income, including capital gains, at ordinary tax rates, which may preclude any state tax-rate arbitrage benefit.

⁶Special rules govern the netting of capital gains and losses. Capital losses first offset capital gains of the same character. A net loss of either type may then offset a net gain of the other type (Sec. 1222).

⁷The 23.8% and 18.8% federal tax rates factor in both the long-term capital gains tax rate and the 3.8% net investment income tax (NIIT). Individual taxpayers may be subject to the NIIT if they have net investment income and their modified AGI exceeds the relevant income threshold: $200,000 for single filers or $250,000 for married taxpayers filing jointly (Sec. 1411).

⁸A large negative tax-rate differential combined with a very short holding period could be especially detrimental to an investor.

⁹Goldberg, Hand, and Cummings, “The Two Different Benefits of Tax-Loss Harvesting: Direct and Deferred,” Aperio Group (August 2016).

¹⁰Aperio Group’s calculations based on MSCI Barra data as of Dec. 31 of each year. Russell 3000 stocks were tracked at the beginning of each year, and any securities not included for the full year were removed. The performance of the stocks is measured using dividend yield-adjusted annual returns and then separated into positive and negative buckets. Investors cannot invest directly in an index.

¹¹This benefit may be reduced if the taxpayer is subject to the alternative minimum tax.

¹²Sec. 1(h)(11)(B)(iii).

¹³For example, an investor selling Pepsi stock at a loss may choose to purchase Coke stock as the replacement security. Alternative wash sale avoidance strategies include remaining in cash during the wash sale period before repurchasing the same security and “doubling up” on the position and then waiting 31 days before selling the original position. Investors may experience differences in returns between a portfolio and its benchmark using any of these strategies.

¹⁴Investors should “do the math” on both the potential benefits of tax-loss harvesting as well as any expected costs. For example, assume the dividend yield of a hypothetical investor’s portfolio is 1.6% and the difference in tax rates between qualified dividends and nonqualified dividends is 17 percentage points when including the NIIT (40.8% – 23.8%). If the investor expects 10% of the dividends to be nonqualified because of loss harvesting, then the tax impact of the loss of qualified dividend treatment might be in the ballpark of 2.7 basis points for such an investor (1.6% × 17% × 10%). Actual results may vary. This cost, along with any other anticipated loss harvesting costs, could then be compared to the expected benefits of loss harvesting.

¹⁵IRS Statistics of Income, Publication 1304, Individual Income Tax Returns 2020 (November 2022).

Contributor

Lincoln Fleming, CPA/PFS, CFP, MAcc., is a senior tax economist with Aperio Group LLC, a wholly owned, indirect subsidiary of BlackRock Inc.

AICPA RESOURCES

Articles

Riley and Furmanski, “Reexamining Tax-Loss Harvesting: Better Results Through Enhanced Understanding,” Tax Insider (Feb. 16, 2017)

Podcast episode

“Harvesting Losses Without Triggering a Wash Sale,” AICPA PFP Section podcast (Nov. 3, 2022)

Resource (Tax Section and PFP Section members only)

Capital Gains Harvesting Chart

CPE self-study

Investment Planning Process

Investment Planning Certificate Program (Exam + Course)

For more information or to make a purchase, visit aicpa-cima.com/cpe-learning or call the Institute at 888-777-7077.