Swedroe: Tax Mgmt Year Round Job

Tax losses should be realized when they are significant, not at the end of the year.

I was asked recently about a situation in which an investor had to sell stocks from his taxable account in order to meet a cash flow need; in this case, a down payment on a home.

He pointed out the “good news” half of his situation. Because the present value of the equities was well below the cost basis, he would have a realized loss. I inquired about the nature of that loss. Was it short term or long term? He responded that it was long term.

I explained that it’s a mistake, albeit one committed by many investors and even advisors, to treat tax managing as a seasonal event and check for losses only at the end of the calendar year. I pointed out that if you have tax losses in taxable accounts, you should almost always realize them whenever they are substantial. And you should also take them before they become long term, as they can be more valuable when they are short term.

He then responded with the following two questions: “What do you mean by ‘substantial?’” and “Why are short-term losses more valuable?”

What's Substantial?

When deciding whether or not a loss is substantial enough to harvest, you should consider three things.

First, weigh the benefit of the deduction relative to any transactions costs involved.

Second, since you don’t want the act of harvesting a loss to impact your asset allocation, you need to immediately buy a similar fund. The better the substitute fund, the lower the hurdle to harvest losses.

For example, a similar fund might be more expensive and/or less tax efficient. That can create a problem, because to avoid the wash-sale rule (and to avoid losing the tax deduction), for 30 days, you cannot buy back the fund you sold. If there is another loss (or even a small gain) in that 30-day period, there’s no problem: You simply sell the replacement fund and buy back your original holding.

A Good Problem Can Arise

On the other hand, if there is a large gain (historically, about 17 percent of months have gains of more than 5 percent), you should think about holding the new fund at least until the gain can be treated as long term (and the tax rate becomes much lower). A good problem can then arise. The gain might become very large, and you will want to hold that new fund for a very long time.

You don’t want to be “trapped” by tax considerations into a costly and/or tax-inefficient fund. That is why it is important to consider the quality of the fund you swapped into.

The third consideration involves the volatility of the asset being sold. The more volatile the asset, the more likely it is that you will have a large gain, creating the problem we just discussed.

The bottom line is that there is no single right answer to what constitutes “substantial.” You have to analyze each situation separately. For example, you might decide that for an S&P 500 Index fund (for which there are perfect—or virtually perfect—substitutes) you will harvest a loss that is at least $3,000, or 3 percent. However, for a more volatile emerging market fund, you might decide to make the hurdle $5,000, or 5 percent.

Why Are Short-Term Losses More Valuable?

Short-term losses are first deducted against short-term gains, which would otherwise be taxed at the higher ordinary income tax rates. Long-term losses are first deducted against long-term gains, which would otherwise be taxed at the lower capital gains rate.

For example, before any loss harvesting has occurred, imagine a taxpayer has realized short- and long-term gains and unrealized short-term losses. These losses can be harvested, and will reduce the short-term gain that would have otherwise been taxed at higher ordinary tax rates.

If the losses were not harvested until they became long term, they would reduce long-term gains, which would otherwise have been taxed at the lower long-term capital gains rate. And that’s just one reason tax management is a year-round job.

The other is that losses that might exist early in the year may no longer exist by the end of the year. Thus, the opportunity to harvest them is gone.

If you are working only part time to harvest losses, you are likely missing opportunities to save on taxes. And if your advisor is getting paid to do a full-time job but working to harvest losses only part time, perhaps you should be seeking another advisor.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.