As the end of the year approaches, it is a good time to think about tax consequences. We don’t wait until year end to focus on tax alpha but it is a good time to reflect back on the current year and make some decisions for 2024. This blog focuses on capital gains and losses and the strategy of tax loss harvesting. Make sure that your advisory team is taking advantage of market dips throughout the year.
PLANNING FOR CAPITAL GAINS & LOSSES
Deciding to hold or sell a position should primarily be an investment decision rather than a tax decision, but understanding the tax implications of that sale can often be a tipping point for a decision. Investors can take advantage of losses in their portfolio through a strategy known as “tax loss harvesting”. Realizing those losses can provide several benefits, and investors should understand how they can help reduce their tax liability.
Capital gains and losses are classified as either long-term (held more than one year) or short-term (held one year or less). Losses are used to offset gains, but it’s important to understand the ordering rules around these transactions.
- Short-term losses first offset short-term gains, and long-term losses first offset long-term gains. If both categories end with a net gain, those gains are then taxed at the applicable rates, with net long-term gains getting the benefit of lower marginal rates.
- If there are net losses in one category, those losses will first offset net gains in the other category with the remaining gain being taxed at its applicable rates.
- If total losses exceed total gains for the year, up to $3,000 of the net loss can be used to offset ordinary income that year, such as wages, business income or retirement distributions.
- Losses in excess of $3,000 are carried over to the next year to offset gains in that year, and these excess losses are carried forward indefinitely.
Even if investors haven’t realized any gains through stock sales this year, there is one source of gain that may very well appear later this year. Mutual fund capital gain distributions can often surprise investors, and preliminary estimates have suggested those gains could be quite substantial this year. When investors redeem their shares in a fund, perhaps out of fear of a falling market, the manager must sell holdings to raise the cash to meet those demands, often triggering gains inside the fund which are then passed out to the remaining shareholders. Those investors who stay in the fund can sometimes get a tax surprise from these unexpected gain distributions. Having some net losses banked earlier in the year can help offset some of this surprise.
Funds typically announce their gain distributions by early December, and they are paid to any investor as of the fund’s record date. This includes those who purchase the fund just prior to that record date. Investors in taxable accounts who are looking to avoid additional gain distributions may want to delay significant investments in a fund until after its record date has passed.
Investors with unrealized losses in their portfolio may be tempted to realize those losses this year as part of a tax loss harvesting strategy, which can provide several benefits:
- Beyond mutual fund distributions, perhaps other gains were recognized in the portfolio, so offsetting those gains can reduce the current year tax bill. That’s especially true if there are short-term gains to offset. Short-term gains don’t get the benefit of lower tax rates like long-term gains do, so offsetting those should be a priority.
- There is also the ability to use $3,000 of that loss to offset ordinary income. As with offsetting short-term gains, using losses against ordinary income can provide a nice tax advantage.
- Net losses beyond $3,000 must be carried over to 2024. While they can still provide value next year, this delay means investors might be more hesitant to realize net losses beyond $3,000.
UNDERSTAND THE WASH SALE RULES
When selling a position and realizing a deductible loss, it can be tempting to repurchase it shortly afterwards, in the hopes of participating in any recovery in value. However, the wash sale rules prevent that from happening. These rules prevent investors from deducting a capital loss from the sale of an item if they buy a “substantially identical” position during a 61-day period, including the 30 days before the sale and continuing for 30 days after the sale. The wash sale rules don’t apply to any sales for a gain, nor do they apply to gifts of appreciated stock to charity. While a loss under the wash sale rules is usually only deferred rather than permanently lost, taxpayers would likely prefer receiving the full tax benefit of any realized losses sooner rather than later.
Other wash sale issues to consider include:
- Selling a security for a loss in a taxable account and then repurchasing it in an IRA or other retirement account will still result in a wash sale. In this scenario, the loss on the sale is permanently lost. Therefore, investors must be aware of their entire portfolio when it comes to avoiding a wash sale.
- With interest rates having risen so much in 2023, the value of individual bond holdings have fallen, sometimes significantly. Those lower bond prices won’t affect the interest those bonds continue to pay, nor will they affect the amount received when the bond matures, but those losses could present an opportunity. A capital loss realized when selling those bonds can be used to offset other gains, while allowing you to purchase a new bond paying a potentially higher interest amount. The wash sale rules apply to bonds as well, so when purchasing a bond from the same issuer as the one you sold (such as a US treasury) be sure the new bond has a material difference in the maturity and/or interest rate from the bond that was sold.
- Investment firms are required to account for wash sales when the exact same position is bought and sold in the same account. However, wash sales involving positions that are not exactly the same but that are still “substantially identical” (such as selling a stock and then buying a call option on the same stock) or that occur across different accounts, are not required to be tracked by those firms. Taxpayers will need to watch for those potential wash sales themselves.
- Individuals who sold at a loss within the past 30 days and want to defer the loss recognition to a later year, when the capital gains rate may be higher, can create an intentional wash sale. The deferred loss could then be utilized once the repurchased asset is later sold.
TAX TREATMENT OF CAPITAL GAINS AND LOSSES
Unfortunately, determining the tax impact of realizing a gain or loss can be very complicated thanks to multiple tax rates, as well as the 3.8% Net Investment Income tax. The tax rules for capital gains (as well as qualified dividends) went virtually unchanged from 2022 to 2023.
- For 2023, married taxpayers with taxable income below $89,250 (singles below $44,625) can realize tax-free long-term capital gains (assets held more than one year). While that doesn’t mean low-income taxpayers can have an unlimited amount of tax-free gains, it does provide them with a planning opportunity. Taxpayers who find themselves below those levels for 2023 should consider realizing some tax-free gains this year. However, they should be sure to work with a tax advisor as there are rules limiting the overall benefit.
- Once taxpayers exceed those 0% rate income levels, long-term gains are subject to a 15% tax rate.
- Taxpayers reaching the highest capital gain bracket are subject to a 20% marginal tax. This rate applies for couples with taxable income over $553,850 and singles over $492,300 in 2023.
- Lastly, couples with Modified Adjusted Gross Income (MAGI) above $250,000 for 2023 ($200,000 for singles) will also owe a 3.8% tax on their investment income over those thresholds. Because MAGI is usually greater than taxable income, taxpayers could be subject to this tax even though their taxable income after deductions ends up below this threshold. Also, the threshold for this tax is not subject to inflation adjustments, so taxpayers whose income was just below the threshold in 2022 may find that they are over it for 2023.
Being aware of these breakpoints can help taxpayers better understand the cost of their investment decisions. For example, for those whose income is expected to drop in 2024 due to retirement, realizing a gain in 2023 may end up costing more in taxes than it would by deferring it to the next year when they could be subject to a lower tax rate. A lower tax rate on the gain also means an investor can withstand a drop in the value of an investment and still have more sales proceeds on an after-tax basis.
On the other hand, the investment risk associated with that deferral can’t be ignored. Investors thinking of realizing a gain late in the year may be willing to accept the investment risk for a bit longer in order to defer the gain into January 2024. Investors facing that same decision earlier in the year may not be so willing to accept that risk for a longer time.
Lastly, avoid the urge to recognize gains in order to “use up” losses realized during the year, only to immediately repurchase the item sold at a gain because it still makes sense to own. Those unused losses can be carried forward to the next year and be used to offset a gain on something you no longer wish to own. Using up losses this year can result in taxable gains in the future that can’t be offset.
If you would like to consider some more advanced strategies to boost your net portfolio returns, give us a call and we would be happy to discuss your situation.