Tax Loss Harvesting: The Basics

After my wife and I submitted our income taxes for 2017, we sat down and uncorked a bottle of Roc’h Avel Clos De L’elu. Our taxes were a little more complex this past year, and it was definitely a good excuse to relax, and indulge in a deliciously crisp glass of wine (or two). Even though I grew up in the Bay Area of California (40 minutes away from Napa), and went to a university in the Central Coast of California (arguably better wine than Napa!), I am not automatically an expert about wine. But, I do know a few things—one being that the grape harvest is a crucial step in the production process. Simply pick the grapes and crush the grapes (an over-simplification!). Harvesting the grapes at the right or wrong time has a tremendous importance to the winemaker’s business and the overall outcome of the finished product.

An investment portfolio is not so different in this regard. Harvesting losses from a portfolio can be an important component to building a successful, tax-efficient portfolio. By utilizing a tax loss harvesting strategy, investors have a great opportunity to reduce their overall tax bills, which could also increase their portfolios’ total return!

It’s a weird strategy, but essentially, the goal of tax loss harvesting is to sell an investment at a loss in order to offset any gains (or to deduct from ordinary income). Note that I didn’t say the goal is to lose money. In addition to selling the “loser,” you actually want to take the proceeds and purchase a similar (not the same) holding. This strategy ensures that you achieve two things: you capture a loss and remain invested.

Here is a basic example:

An investor purchases an investment for $20,000 that tracks the S&P 500 Index (the 500 largest U.S.-based companies) and sells the holding at a loss for $14,000. That investor will have harvested a $6,000 capital loss to help offset against any current or future capital gains. To stay invested, the investor would then use that $14,000 to purchase an investment that tracks the Russell 1000 (1000 largest U.S.-based companies; similar, but not the same as the S&P500), ensuring that the investor would still participate in longer-term returns.

Like a fine bottle of zinfandel, tax loss harvesting is actually fairly complex. Ultimately, deploying a tax loss harvesting strategy takes time, consideration, and an understanding of several factors and rules—but like that bottle of zin, it will be well worth it!