I wrote the following to clients on tax loss harvesting, which is something many investors are either contemplating or doing this time of year.
I enjoy writing about taxes as much as I enjoy going to the dentist. But I feel what I am about to say is important. We – including yours truly – have been mindlessly conditioned to do tax selling at the end of every year to reduce our tax bills. On the surface it makes sense. There are realized gains – why don’t we create some tax losses to offset them?
Here is the problem. With a few exceptions, which I’ll address at the end, tax-loss selling makes no logical sense. Let me give you an example.
Let’s say there is a stock, XYZ. We bought it for $50; we think it is worth $100. Fourteen months later we got lucky and it declined to $25. Assuming our estimate of its fair value hasn’t changed, we get to buy $1 of XYZ now for 25 cents instead of 50 cents.
But as of this moment we also have a $25 paper loss. The tax-loss selling thinking goes like this: Sell it today, realize the $25 loss, and then buy it in 31 days. (This is tax law; if we buy it back sooner the tax loss will be disqualified.) This $25 loss offsets the gains we took for the year. Everybody but Uncle Sam is happy.
Since I am writing about this and I’ve mentioned above I’d rather be having a root canal, you already suspect that my retort to the above thinking is a great big NO!
In the first place, we are taking the risk that XYZ’s price may go up during our 31-day wait. We really have no idea and rarely have insights as to what stocks will do in the short term. Maybe we’ll get lucky again and the price will fall further. But we’re selling something that is down, so risk in the long run is tilted against us. Also, other investors are doing tax selling at the same time we are, which puts additional pressure on the stock.
Secondly – and this is the most important point – all we are doing is pushing our taxes from this year to future years. Let’s say that six months from now the stock goes up to $100. We sell it, and… now we originate a $75, not a $50, gain. Our cost basis was reduced by the sale and consequent purchase to $25 from $50. This is what tax loss selling is – shifting the tax burden from this year to next year. Unless you have an insight into what capital gains taxes are going to be in the future, all you are doing is shifting your current tax burden into the future.
Thirdly, in our first example we owned the stock for 14 months and thus took a long-term capital loss. We sold it, waited 31 days, and bought it back. Let’s say the market comes back to its senses and the price goes up to $100 three months after we buy it back. If we sell it now, that $75 gain is a short-term gain. Short-term gains are taxed at your ordinary income tax bracket, which for most clients is higher than their capital gain tax rate. You may argue that we should wait nine months till this gain goes from short-term to long-term. We can do that, but there are costs: First, we don’t know where the stock price will be in nine months. And second, there is an opportunity cost – we cannot sell a fully priced $1 to buy another $1 that is on fire sale.
Final point. Suppose we bought a stock, the price of which has declined in concert with a decrease of its fair value; in other words, the loss is not temporary but permanent. In this case, yes, we should sell the stock and realize the loss.
We are focused on the long-term compounding of your wealth. Thus our strategy has a relatively low portfolio turnover. However, we always keep tax considerations in mind when making investment decisions, and try to generate long-term gains (which are more tax efficient) than short term gains.
We understand that each client has their unique tax circumstances. For instance, your income may decline in future years and thus your tax rate, too. Or higher capital gains may put you in a different income bracket and thus disqualify you from some government healthcare program.
We are here to serve you, and we’ll do as much or as little tax-loss selling as you instruct us to do. We just want you to be aware that with few exceptions tax-loss selling does more harm than good.
Key takeaways
- Tax loss harvesting, while commonly practiced, often doesn’t make logical sense and can potentially do more harm than good for investors.
- The strategy of selling for a tax loss and repurchasing after 31 days carries the risk of missing out on potential gains during that period, especially when other investors are engaging in similar behavior.
- Tax loss selling merely shifts the tax burden from the current year to future years, potentially resulting in larger capital gains taxes later if the stock price recovers.
- Selling for a tax loss can convert long-term capital losses into short-term gains if the stock price recovers quickly after repurchase, potentially resulting in higher tax rates.
- The only scenario where tax loss selling makes sense is when the decline in a stock’s price represents a permanent loss of value, rather than a temporary fluctuation.
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