Updated July 19, 2023
What is Tax Loss Harvesting?
Tax loss harvesting (referred to as Tax loss selling) is a strategy used by the taxpayer to offset the liability related to capital gain tax that arises on the sale of securities (either short-term or long term securities) by selling the securities at loss and it generally limits the recording of short term capital gain as it is taxed at a rate higher than the rate applicable on long term capital gain under income tax act but it is used to offset long term capital gains as well.
Explanation
Whenever any investor invests in investment funds or mutual funds, he make capital gains. This capital gain may be short term or long-term based on the number of years the investors hold the investment. As per Income-tax Act, short-term capital gains are taxed at a rate higher than the rate applicable to long-term capital gains. By using Tax Loss harvesting, investors can reduce their tax liability. Under tax loss harvesting, Units of funds are sold at a loss so that their capital gain tax liability can be reduced. This method is implemented to offset or set off the capital losses suffered by the taxpayer from the capital gains arise to the taxpayer and it results in a reduction of tax liability.
How Does it Work?
Most investors use this strategy at the yearend, but they can also use this strategy at any time during the year to keep the capital gain tax at a lower level. This process begins with the sale of the security or unit of the fund whose price is consistently declining over the period of time and whose chances of recovery are weak. The loss realized on the sale of a security is used to offset the other capital gain earned by the investor during the period. The amount obtained from the sale of securities (loss making) is used to acquire profitable security. This is necessary to keep the asset allocation intact. It doesn’t help the investor to rescind the losses but it can help them to reduce their tax liability.
Example of Tax Loss Harvesting
The long-term capital gains are taxable at a rate of 20% and short-term capital gains at a rate of 37%. An investor has the following gains or losses for the year from their portfolio:
- Fund Y: $115,000 unrealized loss where security is held for 715 days
- Fund Z: $75,000 unrealized loss where security is held for 100 days
The trading activity of an investor is as follows:
- Fund P: It is kept for 400 days and sold at a gain of $450,000
- Fund Q: It is kept for 145 days and sold at a gain of $100,000
Solution:
There will be long term capital gain if the asset is held for more than one year period whereas there will be short term capital gain if the asset is held for one year period or less than that.
In this case, on fund P there will be long-term capital gain as it is held for 400 days and on fund Q there will be short-term capital gain as it is held for less than one year period
Tax Liability is calculated using the formula given below:
- Tax Liability = ($450,000 * 20%) + ($100,000 * 37%)
- Tax Liability = $127,000
If the investor wants to reduce the tax liability, he can use tax loss harvesting by selling Fund Y and Z and can offset the capital gain earned by the investor during the period.
Tax Liability is calculated using the formula given below:
- Tax Liability = [($450,000-$115,000)*20%]+[($100,000-$75,000)*37%]
- Tax Liability = $76,250
So, there is a saving in tax liability by $50,750 ($127,000 – $76,250). The amount received from the sale of securities can be invested in the acquisition of other profitable securities which are substantially identical to the securities sold at loss by the investor.
Rules of Tax Loss Harvesting
While implementing the strategy of tax loss harvesting, the following rules should be kept in mind:
- While implementing tax loss harvesting, the capital loss arises on the sale of loss-making security is used to set off the capital gain earned by the investor during the period. Further, this loss is also used to offset the non-investment income up to $3000.
- As per the wash-sale rule, the investor cannot repurchase the security which is identical to the loss-making security sold by the investor while implementing tax loss harvesting within 30 days of sale. If it is purchased within 30 days of the sales transaction, the loss arises on the sale of loss making security will not be permitted.
- Tax loss harvesting is not applicable to retirement accounts but it is applicable to taxable investment accounts
Who Does Tax Loss Harvesting?
Tax loss harvesting is done either by:
- The investor on its own or
- By the investment or financial advisor for their clients as it is a very time-consuming or complicated process for investors to manage on their own if the investors have multiple investments.
Benefits of Tax Loss Harvesting
- With the implementation of tax loss harvesting, investors can reduce their tax liability and increase their returns on investments in the long run by selling the loss-making investments.
- Since loss arises from the sale of loss-making security and is used to offset the capital gain earned by the investor during the period, it helps investors to defer their income tax liability to the near future and it allows the portfolio of the investor to grow at a faster rate.
Disadvantages of Tax Loss Harvesting
- It is a very complicated and time taking process as it involves different calculations.
- Sometimes the investor does not handle the tax loss harvesting on its own and outsources the same to the investment advisors. Those investments advisor may charge heavy transaction fees for their work.
Conclusion
Thus, Tax loss harvesting is implemented by the investors to reduce the burden of tax on them by selling loss-making investments and setting off these losses from the capital gain earned by the investors during the period. Generally, it is used to set off short-term gains because it is taxed at a higher rate than the rate applicable to short-term capital gain. While setting off the losses, the investors should be kept in mind that long-term losses cannot be set off from short-term capital gain and short-term losses can be set off against both (Short term or long-term capital gain). This helps investors to defer their tax liability to the near future. This strategy is either implemented by the investors on its own or they make take the assistance of an Investments advisor for the same. So, this strategy is beneficial for the investors having a long-run perspective as they get more returns in the future by rebalancing their portfolio.
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