With inflation at all-time highs and market volatility rattling investors, it is easy to feel defeated. Have no fear, there may be a silver lining to help you save money on your taxes.
Many of the major asset classes experienced volatility this year and values are down year-over-year. You may be able to use investment losses to lower your tax bill by leveraging a strategy called tax-loss harvesting. Tax-loss harvesting has the potential to reduce capital gains you've made in the same year by the amount you’ve lost—and offset ordinary income through a deduction of up to $3,000. Any portion of your loss over $3,000 can be carried forward and claimed in future years.
Things to keep in mind:
Even if you don’t have capital gains, tax-loss harvesting may reduce your taxable income by allowing you to deduct up to $3,000 in losses.
Tax-loss harvesting can only be used with taxable accounts, (like a brokerage), not with tax-deferred accounts (like a 401(k) or IRA).
Tax-loss harvesting can trigger the IRS wash-sale rule, which can disqualify you from claiming your loss in the current tax year. This can happen if you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale.
There are restrictions on using specific types of losses to offset certain gains. A long-term loss would first be applied to a long-term gain, and a short-term loss would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type.
You do not need capital gains to take advantage of tax loss harvesting.
Any losses you realize in 2022 can be used to offset ordinary income up to $3,000 come tax time, and excess can be carried forward. Further, you may also be able to employ tax loss harvesting without materially changing the long-term risk and return characteristics of your investment portfolio. For example, if you held bond funds this year, you likely are sitting on losses in those funds. You could sell those funds, bank the capital losses, and reinvest in the same fund after the 30-day required waiting period (see wash sale rule). You do run the risk of the price of the fund increasing in that 30-day period, but the compounded tax benefits may outweigh this risk, especially if those losses are large.
If you are sitting on large long-term capital gains, this is the time to act, even if you intend to wait to realize those gains.
If you have large capital gains you have earmarked to sell at some point to reduce overall portfolio risk, this is your moment. Whether you recognize the gains this year or wait, you can take any losses in the current year and “save” them to offset future capital gains, which would certainly be advantageous if you plan on having large future gains. Further, if reducing risk is an important portfolio goal and with a direct plan to sell those investments, you could easily justify this being a “good” time to sell since your capital gain would be comparatively lower, thus lowering your tax bill.
Short term capital gains can be a compelling story.
Imagine you are reviewing your portfolio and you managed to pick an investment that has a $20,000 gain (Investment A). You held the investment for less than a year, so the gain is treated as a short-term capital gain and will be taxed at the higher ordinary-income rates (rather than the lower long-term capital-gain rates, which apply to investments held for more than a year). At the same time, you can sell another investment for a short-term capital loss of $25,000 (Investment B). Your $25,000 loss would offset the full $20,000 gain from Investment A, meaning you'd owe no taxes on the gain, and you could use the remaining $5,000 loss to offset $3,000 of your ordinary income. The leftover $2,000 loss could then be carried forward to offset income in future tax years. Assuming you're subject to a 35% marginal tax rate, the overall tax benefit of harvesting those losses could be as much as $8,050! Let's look at how this works.
© Charles Schwab & Co., Inc.
BONUS: The wash sale rule does not apply to cryptocurrency!
The wash sale rule currently only applies to assets classified as stocks or securities and other financial instruments that are traded on organized exchanges. Cryptocurrency is classified as property by the IRS and is currently not subject to the wash sale rule. An investor in a virtual currency can sell their position to lock in a capital loss and immediately repurchase the currency without losing exposure to the cryptocurrency! You do not have to wait 30 days. This is huge!
The popularity of cryptocurrencies or virtual currencies continue to draw the attention of federal lawmakers. Under the Build Back Better Act, which has been defeated in the U.S. Senate, digital assets such as cryptocurrency would have been treated the same as stock and securities in applying the wash sale rule for federal income tax purposes, and applicable to tax years beginning after December 31, 2021. You can thank the political gridlock for that bill not becoming a law, but you can bet that other bills are expected in the future that would apply the wash sale rules to cryptocurrencies.
More important notes on crypto: Taxpayers are currently required to carefully track their transactions in cryptocurrency, as well as their basis. This becomes complicated if the taxpayer uses multiple cryptocurrency exchanges or wallets. When the wash sale rules become applicable to cryptocurrencies, this will add an additional layer to the complications that already exist. Additional reporting requirements for cryptocurrency were already enacted by recent legislation. Brokers are now required to report cryptocurrency transactions on Form 1099-B, including a customer’s basis, beginning after 2023. Digital assets are treated as cash and require reporting from any person that receives cash transfers of more than $10,000 in a trade or business.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment and/or tax advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs, and when rebalancing a nonretirement account, taxable events may be created that may affect your tax liability. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner, or Investment Manager. Investing involves risks, including loss of principal.
Sources: “Tax Savings Moves You Can Make Before Year-End”, Charles Schwab Institutional, Hayden Adams, November 9, 20222 (paraphrased); “Wash Sale Rules and Cryptocurrency Tax Planning for 2022”, Anders CPAs, Mariah Theves, August 2, 2022; “How to Cut our Tax Bill with Tax Loss Harvesting”, Charles Schwab Institutional, Hayden Adams, September 28, 2021 (paraphrased)