ETFs Made Easy: Tax Loss Harvesting

David Nadig for ETF.com writes: If there are two things nobody likes doing universally, it’s losing money and paying taxes. Thankfully, if you’re an ETF investor, there’s a pretty easy way to use one to offset the other.

It’s called “tax loss harvesting,” and while that may sound like something involving Cayman Islands bank accounts and expensive accountants, it’s actually dirt simple.

Offsetting Gains With Losses

The basic principle is this: If you’re sitting on a position—in anything really: a stock, a mutual fund or an ETF—that has a loss since the time you bought it, you can use that loss to offset any gains you might have.

Imagine you have a loss of $1,000 in one ETF that you’ve held for a year, and a gain of $1,000 in a different ETF. You can use one to offset the other.

So how and why might you do this? Well, there are a lot of ETFs that are up this year. Take the wildly popular WisdomTree Japan Hedged Equity ETF (DXJ | B-65). It’s up about 7.5 percent this year. If you sold it recently to lock in your gains, you’re probably sitting on that 7.5 percent gain—more if you’ve held it for longer.

Even if you haven’t sold it, WisdomTree just made a large distribution of capital gains accrued inside the portfolio, meaning you’re sitting on some combination of long- and short-term capital gains, whether or not you sold it.

But chances are, if you’re like most investors, not everything in your portfolio worked out. So if you sell one of your losers, you can book that loss to offset the gain, and owe less, or maybe even no taxes.

Wash Sales Not Allowed

So what’s the problem? Well, unless you’d just given up on XYZ, you still want to be exposed to XYZ. That’s where ETFs come in.

Now, the IRS has rules … they won’t let you sell XYZ, book the loss and then just buy it back again. That’s called a “wash sale” if you do it within 30 days of the sale, and it’s a no-no.

But with ETFs, it’s often easy to get similar—but not identical—exposure. The general rule of thumb is that you can’t swap two funds tracking the exact same index. You can’t sell yourSPDR S&P 500 (SPY | A-99) and buy the iShares S&P 500 (IVV | A-99) to replace it.

But if what you really want is large-cap exposure, you could move into either a different version of the S&P 500, say, the WisdomTree Earnings 500 (EPS | A-95), or a different take on large-cap, like the Vanguard Megacap (MGK | A-95).

Your returns won’t be exactly identical, but they’ll likely be very close, at least for the period you’re waiting for the wash-sale clock to expire.

Important Steps

There are a few important notes in implementing a tax-loss harvest:

• Even if you don’t have any gains to offset, you can use up to $3,000 in losses to offset your regular old income. It’s not much, but it’s something. Any excess losses will carry over for the future.
• None of this matters in tax-deferred accounts like IRAs and 401(k)s.
• You don’t need to worry about whether the losses you book by selling are short term or long term—both can be used to offset any capital gains.

So where might you find these offsetting losses to take a bite out of the tax man? Here are the top 10 ETFs with year-to-date losses (making them likely candidates to sell), and ETFs you could consider replacing them with to maintain your exposure.

Ticker	Fund	AUM ($)	Segment	1 Year	Potential Swap
EFA	iShares MSCI EAFE	52,394,016,000	Equity: Developed Markets Ex-U.S. - Total Market	-1.71%	VEA
VWO	Vanguard FTSE Emerging Markets	45,112,555,000	Equity: Emerging Markets - Total Market	-0.71%	EEM
EEM	iShares MSCI Emerging Markets	31,324,171,500	Equity: Emerging Markets - Total Market	-3.98%	IEMG
GLD	SPDR Gold	26,953,632,500	Commodities: Precious Metals Gold	-3.69%	DGL
VEA	Vanguard FTSE Developed Markets	23,793,033,600	Equity: Developed Markets Ex-U.S. - Total Market	-1.90%	EFA
EWJ	iShares MSCI Japan	14,420,544,000	Equity: Japan - Total Market	-1.98%	DXJ
VEU	Vanguard FTSE All-World ex-US	12,419,997,700	Equity: Global Ex-U.S. - Total Market	-1.34%	IXUS
VGK	Vanguard FTSE Europe	11,435,549,100	Equity: Developed Europe - Total Market	-1.95%	EZU
XLE	Energy Select SPDR	11,153,987,820	Equity: U.S. Energy	-7.97%	IYE
JNK	SPDR Barclays High Yield Bond	9,517,240,533	Fixed Income: U.S. - Corporate High Yield	-0.54%	HYG

As with any ETF, you should take a hard look the recommended swaps here to make sure you understand what you’re buying. By definition, they’re not perfect corollaries; they’re just good enough for a 30-day period.

The PowerShares DB Gold (DGL | C-57), for example, holds futures, not gold bullion, so it isn’t a perfect substitute for a losing position in the SPDR Gold Trust (GLD | A-100), but it will likely catch any big move in gold. The same can be said for most of these swaps.

The good news is this: Most ETFs have actually been in the green for the last 12 months. But if you’re unlucky enough to be sitting on a loser, make it work for you.