Contributed by: Nicholas M. Brown, CFA, CFP

2024 is shaping up to be another banner year for equity investors, with the S&P 500 up over 20% for the year at the time this article was written. To the extent those gains occur in accounts with capital gains exposure, a positive market could also create the possibility for significant tax liability.

One way to address capital gains exposure is through Tax Loss Harvesting. Tax loss harvesting is often celebrated as a key tool for tax efficient investing, allowing investors to use market losses to reduce their tax liability. While its benefits are clear in volatile or bearish markets, the role of tax loss harvesting in a positive market is more nuanced.

This strategy involves selling investments at a loss to offset taxable gains, lowering your immediate tax bill. However, investors should approach tax loss harvesting with careful consideration, as its potential downsides could outweigh the advantages in certain situations.

In this article, we’ll explain how tax loss harvesting works, explore its pros and cons, and provide practical insights for determining when it may—or may not—be appropriate for your portfolio.

The Mechanism of Tax Loss Harvesting

Tax loss harvesting is a structured process aimed at leveraging market fluctuations to optimize tax outcomes. Here’s how it works:

1. Identify Investments with Losses:
   Examine your portfolio for investments currently trading below their original purchase price.
2. Sell the Underperforming Assets:
   Sell these investments to realize a capital loss. The loss can be used to offset capital gains from other investments or, in some cases, ordinary income.
3. Reinvest in Similar Securities:
   To maintain your market exposure and adhere to your investment strategy, reinvest the proceeds in similar—but not identical—securities. This avoids violating the IRS wash-sale rule, which disallows the tax deduction if you repurchase the same or substantially identical investment within 30 days before or after the sale.
4. Use the Losses on Your Tax Return:
   Apply realized losses to offset gains in the same tax year. If losses exceed gains, you can deduct up to $3,000 against ordinary income, with any excess carried forward to future years.

While this process appears straightforward, its implications extend beyond immediate tax benefits.

Pros of Tax Loss Harvesting in a Positive Market

1. Offset Gains to Reduce Taxable Income
   Tax loss harvesting provides a way to manage capital gains taxes, to the extent that a loss is available in a positive market. By offsetting gains with losses, you can reduce your taxable income for that year and potentially improve your after tax returns.
2. Create Opportunities for Portfolio Rebalancing
   Positive market conditions often lead to imbalances in portfolio allocations. Tax loss harvesting can enable rebalancing without incurring additional taxes from selling appreciated assets.
3. Strategically Exit Underperforming Investments
   Tax loss harvesting allows you to part ways with assets that are underperforming or no longer fit your investment strategy.

Cons of Tax Loss Harvesting in a Positive Market

1. Lower Cost Basis in Your Total Portfolio
   A key downside of tax loss harvesting is that it can reduce the cost basis of your portfolio over time. This occurs when you sell a depreciated asset and reinvest in a similar one at a lower price. While this may not seem problematic in the short term, it can increase the capital gains tax burden when you eventually sell those reinvested assets. In essence, today’s tax savings could translate into higher taxes later, especially if you start taking withdrawals from that account.
2. Risks of the Wash-Sale Rule
   The IRS wash-sale rule prohibits claiming a tax deduction if you buy the same or substantially identical investment within 30 days of the sale. This requires careful planning to ensure the Wash-Sale Rule does not eliminate the value of the loss that was harvested.
3. Opportunity Cost of Selling Recovering Assets
   Rising markets often lead to rebounds in previously underperforming investments. Selling such assets to harvest losses could mean missing out on potential future gains, which may outweigh the immediate tax benefit. Maintaining exposure in a similar – but not identical – security is meant to combat that, but there is no guarantee that the substitute security will perform exactly like the one being sold.

Practical Scenarios

When Tax Loss Harvesting May Be Appropriate

• You have realized significant capital gains that need to be offset.
• You are in a high tax bracket with the expectation of being in a lower tax bracket later.
• You want to rebalance your portfolio in a tax efficient way.

When Tax Loss Harvesting May Not Be Ideal

• The losses are negligible, offering minimal tax benefits.
• You expect to be in the same or higher tax bracket later, either through income or legislative changes.
• Your reinvestment options are limited, increasing the risk of market timing or reduced diversification.
• You want to avoid reducing your portfolio’s cost basis and the potential for larger tax burdens in the future due to planned withdrawals or cash flow needs.

Example:
Suppose you hold shares in Stock X, purchased at $60 but now trading at $45. Selling it would realize a $15 loss per share, which you could use to offset a $15,000 gain from another sale. You reinvest in a similar ETF to maintain market exposure. While the immediate tax benefit is clear, the reinvestment has a lower cost basis, potentially leading to higher taxes when you sell it later.

Conclusion

While tax loss harvesting can provide meaningful tax benefits, its application requires careful consideration. Lowering your portfolio’s cost basis, the risks of wash-sale rule violations, and potential disruptions to your long term strategy are factors to weigh against the tax savings that tax loss harvesting could create.

Ultimately, tax loss harvesting is not a one size fits all solution. Investors should evaluate whether the strategy aligns with their broader financial goals, risk tolerance, and tax planning needs. Other tax strategies, such as strategic gifting, ensuring proper asset location, deferring gains to a different tax year, and creating tax diversification across your investment accounts could also lead to reduced total tax liability and be potential substitutes for the tax savings generated through tax loss harvesting.

If you’re considering tax loss harvesting as part of your investment strategy, consulting with a knowledgeable financial advisor is essential. At Granite Harbor Advisors, we specialize in designing tax efficient strategies tailored to your unique circumstances. Contact us today to explore how we can help you optimize your portfolio and achieve your financial goals.