Loss harvesting – selling a security at a loss, which your client can then use to offset capital gains incurred on another, better-performing investment – is a familiar tax-saving tactic. It can be important for high-income earners and residents of states where short-term capital gains are higher than the long-term capital gains’ rate.
A new investment tool in the box is the exchange traded fund (ETF).
Generally, the efficacy of tax-loss harvesting applies regardless what investment vehicles your client uses. As usual in investing, diversity is best: Harvesting losses in individual stocks means your client risks missing out on a burgeoning sector.
Your client can replace the sale with a similar (but not identical) ETF.
ETFs offer participation in a niche that perhaps your client had to sell from or wants to use for portfolio diversification. ETFs can maintain the same exposure while realizing the tax benefits, and tend to offer lower administrative fees. Traders can work with your client to tailor ETFs to individual investment needs.
The SEC also recently green-lit several asset-management companies to operate active ETFs without disclosing holdings daily – an important boost in the competitive use of ETFs in trading.
Though your client might think of funds as too unfocused (compared with a specific security) to generate good returns, some ETFs offer highly targeted investments. For example, a focused health-care industry ETF could drill into a specific segment of the health care sector, such as biotechnology, medical equipment providers, life sciences services, or pharmaceuticals.
Note: If any losses remain after your client has offset all gains, the remaining losses can be offset against as much as $3,000 of ordinary income. Losses beyond that can be carried forward to future years.
How to avoiding swapping “identical” holdings
The sold investment can be replaced within 30 days for tax-loss harvesting, but only if the new investment isn’t similar to the one sold (aka, the “wash sale” rule). The IRS term is “substantially identical,” yet the agency goes into sketchy detail on the definition.
According to IRS Publication 550, Investment Income and Expenses, ordinarily stocks or securities of one corporation are not considered substantially identical to stocks or securities in another corporation – “however, they may be substantially identical in some cases.”
It is safe to say that if your client sells a specific stock in a specific sector and then invests in an ETF in that sector, the exchanged holdings aren’t substantially identical.
The key point for tax-loss harvesting: ETFs themselves often aren’t similar, either, differing from fund company to company in structure, expense ratios, returns and other details. They can help diversify a client’s portfolio.
Note that two ETFs that track the same index are considered similar for purposes of the wash sale rule. This is an easy fix: If your client has a losing losing position in an ETF that tracks the Russell 1000, for instance, replacing it with an ETF that tracks the Standard & Poor’s 500 fulfills the requirement to avoid wash sale rules.
Watch the details
This tactic doesn’t work in all investing scenarios. For instance, it obviously only works for taxable accounts and not for such holdings as a 401(k) or an individual retirement account. The new ETF may not produce returns as robust as that of the stock sold. Your client also needs to make sure the tax savings outweigh the costs of the transaction.
And though maybe not a drawback, ETFs do hold the promise of good returns (although perhaps over a longer time than stocks), which raises the specter of eventual capital gains. If the new ETF increases in value over 30 days and your client wants to sell it to re-invest in the original stock, short-term capital gains also kick in.
Among other concerns:
- Does your client truly want to sell the securities to realize the loss? The client might be thinking to themselves that the holding still has good long-term potential.
- Established, high net worth clients might find ETF investing too limited, and find tax-loss harvesting with individual stocks more effective.
- If your client re-purchases the securities sold, those stocks will probably have a lower tax basis than when originally bought. Selling for a higher price can result in a taxable gain.
- ETFs, just like stocks, come with their own potential problems. Research how the ETF will affect your client’s portfolio and investing strategy.
As always, visit with your clients and offer your guidance as their trusted advisor.