Tax Loss Harvesting – Taking Advantage of Volatility

Tax loss harvesting is the portfolio management practice of selling a security that has experienced a loss in order to capture tax savings.  Realized capital losses can be used to offset future realized capital gains. Any realized losses that are not utilized in any one year can be “carried forward” indefinitely.  Further, investors who don’t have taxable gains to offset in any one year can use their tax loss carry forward to offset up to $3,000 of ordinary income annually.

In the current environment, there have been certain segments of the market that have exhibited meaningful pullbacks.  For example, the S&P 500 Energy Index has exhibited a total return of -19% for the year (through September 9, 2015) while the MSCI Emerging Markets Index is only slightly better at -14%1.  These are two areas within client portfolios where Sigma has been deliberately looking for taxable losses to harvest.

There are a few caveats that are worth noting when considering tax loss harvesting.  First, securities that have had sharp pullbacks can exhibit rather quick and unpredictable recoveries.  For example, the MSCI Emerging Markets Index had a total return of -53% in 2008, only to recover with a 78% total return in 20091.  Second, the IRS will disallow any loss when a substantially identical security is purchased within the 30 days prior to, or the 30 days after the loss sale.  This prevents investors from selling a security for a loss and immediately buying it back to take advantage of a potential price recovery.

In giving consideration to the two aforementioned caveats, Sigma will usually sell securities with meaningful tax losses, immediately buy a similar (but not substantially identical) security, and revisit the trade in 31 days to assess whether or not a swap back to the original holding makes sense.  If a similar security isn’t available, there is also the option of buying additional shares of the same security and waiting 31 days, at which time the original shares that are at a loss can be sold.

For investors who are in higher tax brackets, federal ordinary income tax rates and short-term federal capital gains rates can be as high as 39.6%.  Long-term federal capital gains rates are slightly less punitive, but can be as high as 23.8%.  While the resulting tax savings from tax loss harvesting won’t show up on a portfolio performance report, it will make a material difference on future tax returns.

If you have positions in your taxable investment accounts that are currently at a substantial paper loss, it may be worth considering a tax loss harvesting strategy.

All comments and suggestions are welcome.

Christopher W. Frayne, CFA®, CFP®

1Source:  Bloomberg