Tax loss harvesting: When realized losses may be less useful
December 19, 2024
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5 min read
Tax-loss harvesting can be seen as the silver lining to an investment losing value. The strategy allows investors to use realized losses to offset realized gains, reducing tax impact and keep more money invested and growing. Despite the benefits of tax loss harvesting, there are times when the usefulness of realized losses is diminished.
Generally, capital losses are least useful when they cannot be fully leveraged because of limited gains, low tax rates, or limitations on how much income they can offset. Since the goal of tax planning is to reduce lifetime tax liability, knowing when losses may not be as useful can aid in planning.
Here are six times when harvested losses may be less beneficial to a taxpayer:
1. When income is reduced. If the taxpayer is temporarily in a lower income tax bracket, in between jobs, or recently retired but not taking Social Security or required minimum distributions, using losses to offset lightly taxed gains is suboptimal. Ideally, losses are used to offset short-term gains when the taxpayer is in their normal/higher tax bracket. The Internal Revenue Service (IRS) doesn’t permit taxpayers to use carryover losses opportunistically (i.e., only in high tax years); losses must be used to offset any realized gains or reduce income by $3,000.
2. When tax rates decline. Excess realized losses (i.e., above realized gains) are limited to offsetting $3,000 in ordinary income. Losses exceeding this amount can be carried over to future tax years; however, the benefit can be reduced if tax rates decline. That said, banking current losses to offset a known future capital gain, such as the sale of a business, real estate, or appreciated stock, can act like an insurance policy against future tax rate volatility.
3. When the wash sale rule is violated. A harvested loss that violates the wash sale rule results in a realized loss that cannot be deducted (i.e., a disallowed loss). The disallowed loss is usually deferred to a future date because the cost basis of the replacement security is adjusted higher by the disallowed loss. For example, a wash sale violation with a $2 disallowed loss on a $10 stock will increase its cost basis to $12. If the price remains stable and is sold for $10 after the wash sale period, the $2 loss will be recognized and claimable.
Complications occur in the following scenarios:
- A wash sale straddles tax years, which may result in the loss being recognized in a year when the deduction is worth less because of lower income or no gains to offset.
- The taxpayer dies before the loss on the replacement stock is recognized.
- The loss is harvested in a taxable account, and the replacement security is purchased in a tax-deferred or tax-exempt account (such as an IRA or Roth IRA, respectively). This results in the disallowed loss being permanently barred because the subsequent loss will be realized in a nontaxable account.
4. When carryovers outlive investors. It’s often said that capital losses carry forward indefinitely, but they do expire upon death. A surviving spouse can use the deceased spouse’s capital loss carryforwards to offset realized gains in the year of death on their final joint tax return. Any losses not offset in that year are extinguished and unavailable for the surviving spouse.
5. When investments are primarily in tax-advantaged accounts. When an investor is building up savings in a tax-advantaged account (e.g., 401(k), Roth IRA, Health Savings Account, 529 Plan), there may be little to no savings left to fund taxable accounts. In this scenario, heavy realized losses in taxable accounts may not be useful beyond the $3,000 limit or for years to come.
6. When other tax shelters may be more appropriate. A real estate investor who sells a property at a gain, for example, might be better off using the Section 1031 like-kind exchange to defer capital gains tax rather than realizing the gain and using losses to reduce their tax liability. Furthermore, a loss realized on the sale of personal-use property, such as a primary residence, is neither deductible against gains nor eligible for the $3,000 income deduction.
Systematically tax-loss harvesting taxable equity accounts, such as Direct Indexing portfolios, can provide consistent and reliable tax alpha for investors. More losses are better, and short-term losses are the best. In certain situations, the usefulness of losses may be temporarily diminished as noted above. Advisors who understand the exceptions to the rule can offer more complete tax planning advice to their clients.
