Tax loss harvesting

Since the stock market is down about 5-10% from its all-time highs, I wanted to cover this topic.

One of the advantages of a taxable brokerage account is the ability to perform tax loss harvesting.

Tax loss harvesting is the process of selling your shares at a loss and buying back a similar equity or ETF. The loss then becomes a tax-deductible event, generating tax savings. You can deduct up to $3,000 of losses per year on your taxes.

So, how does the process work exactly?

Here’s a quick example:

Let’s say you received a $10,000 bonus and decided to invest it all in the S&P 500 ETF, VOO, on July 16th, when the price was $519 per share. This purchase got you approximately 19 shares.

By August 6th, the price of VOO drops to $480. You weren’t planning to sell, so the drop might not seem important, right?

Well, you could actually receive a nice tax deduction. If you sell all the shares at $480, you would realize a $39 loss per share. Selling all of them would result in a $741 paper loss that you could deduct on your taxes. If you are in a 30% tax bracket, that’s $220 saved just on federal taxes.

You could then immediately go ahead and buy VTI, a Total US Market ETF. VOO and VTI have an 87% overlap by weight, so their performances are very similar:

If the market continues to drop, you can repeat the process with selling VTI and buying VOO. 

You cannot buy a “substantially identical” security or ETF; otherwise, your loss will be subject to a “wash sale” and will not be deductible. Important to add that cryptocurrencies are not part of the “wash sale” rules since they are not securities, and you could sell coins at a loss and buyback them immediately.

So, what is “substantially identical”? The IRS doesn’t explicitly define it but suggests that you must consider “relevant facts and circumstances.”

Generally, stocks of two different companies are not considered substantially identical. In terms of ETFs, if they track different indexes, they are not substantially identical. In my opinion, if an ETF tracks the same index, like VOO (which tracks the S&P 500) and SPY (which also tracks the S&P 500), they would be considered substantially identical.

The best time to engage in tax-loss harvesting is when your tax rate is the highest. For example, if your tax rate is 30%, you would essentially save 30% for every $1 of loss (up to $3,000).

It’s important to understand that the wash sale rule ‘resets’ the cost basis. So, if you sell VOO at $480 after originally buying it at $519, the next ETF or stock you purchase will have a cost basis that is $39 lower, which could result in higher capital gains later on.

However, if your heirs inherit the account, they would receive a step-up in basis, which would eliminate the capital gains.

A few important things I want to add:

1. Before you sell, you need to understand your cost basis method. The options include FIFO (First In, First Out), LIFO (Last In, First Out), and specific identification. This is especially important if you’ve been buying the same stock for many years and want to sell only the most recently purchased shares. The best cost basis method for tax-loss harvesting purposes is specific identification, as it allows you to select exactly which shares you want to sell
2. It will be considered a wash sale if you buy any shares of the same ETF in a taxable account or IRA within the 30 days before or after the sale. You can repurchase the exact same ETF on the 31st day, but you might miss out on potential gains during that time.
3. You cannot buy the same fund you sold in any of your accounts. For example, you cannot sell VOO in your taxable account and then buy VOO in your IRA the next day; otherwise, the loss will be subject to a wash sale. A good way to avoid this is to buy different funds across your accounts, so there is no risk of triggering the rule. This also applies across different brokers you might have (e.g., Vanguard, Fidelity).
4. Lastly, turn off automatic dividend reinvestment. Dividend reinvestment will trigger a purchase of the fund, and the newly purchased shares will be subject to the wash sale rule unless you sell them as well.

I hope you learned something new today.

See you next Saturday.

MC, CPA