Using tax-loss harvesting and substitution to pay less in taxes today

Posted on Posted in Financial Blog

NOTE: This article only applies to TAXABLE investment accounts. Capital gains are NOT a consideration in TAX-DEFERRED accounts (401(k), IRA, SEP, etc.). Also, we are not tax professionals, so we recommend that you consult your tax professional before you make any decisions with respect to tax planning.

For investors, a major component of the total income tax you pay is taxes on capital gains. To calculate your capital gains in a given year, net out your realized investment gains and losses—that is, gains and losses on investments sold that year, plus any losses carried forward from prior years. Capital gains are considered either short- or long-term and are taxed differently— short-term assets are held for one year or less, while long-term gains apply to assets held for longer than one year. Short-term gains are taxed at the investor’s (highest) ordinary income rate while long-term gains are taxed at a 15% rate for most investors (20% for the highest income bracket, 0% for the lowest bracket).

What is tax loss harvesting?

Tax-loss harvesting is something investors do to reduce their capital gains taxes. It involves taking losses for the purpose of offsetting capital gains. Investors usually wait until December to do their tax-loss harvesting, but that doesn’t mean you can’t offset gains any time of year. Let’s say you have $15,000 in realized investment gains for the year and want to wipe out the taxes on those gains. To reduce your taxable gains for the year, you sell an unrealized position at a loss. In this case, you would create a loss that offsets some (or all) of your $15,000 gain. You can even create an overall capital loss for the year: $3,000 of this can offset ordinary income, and the rest can be carried over to future years. In theory, tax-loss harvesting sounds like an easy decision, but in reality it can be emotionally difficult  to take a loss on a stock you thought was going to perform well, especially if you still like it as a long-term investment.

Note that if you sell a security and buy it back within 30 days, this is considered a “wash sale” and the IRS will not allow you to recognize a loss. For example, if you bought Apple (NASDAQ: AAPL) at $700 in September 2012 and you sold your position today at a loss, only to re-initiate it at any point within the next 30 days, the IRS will consider this a “wash” and will treat it as if you never sold the stock. In order to take a capital loss on your AAPL shares you would have to wait at least 31 days to buy back the stock.

Substitution

What if you could get the benefits of tax-loss harvesting without necessarily losing out on the potential gain from the asset you’re selling? Well, (sometimes) you can. Note that correlation, discussed below, is a measurement of how assets move in relation to each other. Highly correlated stocks move in tandem with one another.

Let’s say your AT&T (NYSE: T) position has lost value since it was purchased, and you want to sell your AT&T stock to pare other capital gains. Through substitution you could purchase stock in a company comparable to AT&T (a company whose stock correlates highly with AT&T stock). Naturally, industry sector is a very significant determinant of how two stocks will correlate. High correlation is more likely between two companies in the same industry, and is more likely when two companies’ revenues come from the same region(s) of the world. In this case, Verizon (NYSE: VZ) is a good substitute.

If you sell $10,000 of AT&T stock in order to take a loss, you can put that $10,000 into Verizon stock and probably capture the same benefits you would have gained by holding onto your AT&T, a small risk given the guaranteed benefit of the tax savings. Certainly there are events that could affect stock prices at one US telecom giant but not the other, regardless of how similar the companies’ operating environment may be, but over the long-term the stocks move so similarly that the “risk” is almost certainly worth the reward. Plus, 31 days after you sell your AT&T stock you could switch it back into the portfolio and sell Verizon (or just hang onto the Verizon if you are indifferent between the two).

Keep in mind that AT&T/Verizon is a rare example of two companies that are incredibly similar (same industry sector, same sub-sector, similar revenue bases, similarly-sized, etc.) and you won’t always be able to find such close substitutes. There is no such thing as a perfect substitute, but almost every stock has a similar company you can plug into your portfolio to take advantage of a tax-saving opportunity.