Tax Loss Harvesting: Beware of Unrealistic Expectations

Daniel S Kern for ThinkAdvisor writes: Tax loss harvesting used to be an end of year tradition – with advisors and individuals poring over account statements to identify stocks that could be sold at a loss in December to reduce taxes paid the following April. 

The intersection of academic research and technology has turned tax loss harvesting into a year-round activity for some clients, popularized first for larger investors by a few innovative asset managers and private banks and more recently for the mass market by online advice providers. 

Tax Loss Harvesting

Tax loss harvesting strategies are most effective when funded with cash, though in many cases we see strategies funded with the combination of cash and a legacy stock portfolio. Clients often turn to tax loss harvesting strategies after an active relationship has “gone wrong,”seeking a lower-cost and more tax-sensitive alternative to active management. 

The most common approach to harvesting involves equities (though it can also be used with less effectiveness for portfolios of ETFs or mutual funds), with the portfolio manager building a portfolio that attempts to track an index before taxes while generating enough tax losses to beat the portfolio after-tax. 

The strategy takes advantage of the natural movement of stock prices, identifying losses among portfolio holdings and selling those positions to capture the loss. As stocks are sold, replacement securities are purchased so as to maintain the portfolio’s risk positioning relative to the benchmark. 

For example, it’s common to replace similar securities for one another, such as Coke for Pepsi, Exxon for Chevron or Bank of America for Wells Fargo. Risk models help to identify less obvious substitutions, but these intuitive examples provide a good example of the risk management approach inherent in the strategy. Realized losses generated by the strategy are intended to be used to offset gains, thereby reducing or deferring tax pain.

Concentration Stock Positions

An increasing number of investors hold a significant portion of their net worth in company stock and options. Although they are passionate believers in their company, many are all too aware of the risk associated with concentrating their net worth in a single company. Memories of the demise of companies such as Enron, AIG and Bear Stearns are all too fresh, and clients realize that events beyond their control could cause them to lose their nest egg and career at the same time. 

One common method used to “un-lock” concentrated potions is a tax loss harvesting portfolio. Tax loss harvesting is a way to reduce the tax impact of selling a portion of the concentrated holding, and facilitates the creation of a more diversified portfolio.

Assumptions

There are a few key assumptions that inform our thinking about tax loss harvesting, and have meaningful implications for the success of the strategy.

• Portfolio tax status:Harvesting strategies only work in taxable portfolios!
  
• Offsetting capital gains: A critical assumption is that the client will have realized gains to offset; realized capital losses can only offset a small amount of ordinary income each year.
  
• Capital losses only delay the tax bill: Harvesting strategies may delay taxes, but eventually most clients will pay taxes on their appreciated securities, unless they gift the securities to charity or leave them to beneficiaries who receive a step-up in basis at death.
  
• Tax planning is critical: Clients who expect to be in higher tax brackets in the future may want to accelerate rather than delay gain realization!
  
• Loss harvesting results typically decline over time: Unless cash is regularly added to a portfolio, a strategy of selling “losers” while holding on to “winners” often leads to a portfolio filled with stocks held at gains, limiting the opportunity to take losses. The best results in a tax loss harvesting strategy are often found in the first five years.

Beware of Inflated Claims

We’ve noted with a mix of amusement and consternation lofty claims about the effectiveness of tax loss harvesting from some online advisors (also known as robo-advisors). Although we are proponents for harvesting strategies, some of the claims we’ve seen are unrealistic given our more than a decade of experience managing tax loss harvesting portfolios and results we’ve seen from competitors we respect.  

The claims made by online advisors arguably represent the triumph of favorably simulated back-tested results over actual experience. Although we believe that back-testing simulations serve an important role in portfolio management, we are skeptical of investment managers who use back-tested results too prominently in their marketing campaigns. 

Conclusion

Investor and media attention typically is devoted to high-profile managers that have eye-catching returns. This is an understandable fact of life in a headline-driven world, but in our view performance tends to be hard to predict and few managers deliver market-beating performance over extended periods of time.  Taxes are often a “silent killer,”eroding investor returns while getting insufficient attention other than in the days leading up to year end or April 15. 

The good news for investors is that they can take steps to manage their tax bill, with a tax loss harvesting strategy being an easy-to-implement, low cost and transparent way to do so. 

Pros And Cons Of Annual Tax-Loss Harvesting

Roger Wohlner for Investopedia writes: With the end of the year upon us investors are looking for ways to reduce their tax bills. One tactic that is often used is tax-loss harvesting. Tax-loss harvesting is the strategy of selling stocks, mutual funds, exchange-traded funds (ETFs), and other investments that are worth less than you paid for them in order to use those losses to offset realized gains on other investments.

Is this strategy a good idea for you? It depends.

MORE THAN JUST TAX CONSIDERATIONS

It's generally a poor decision to sell an investment, even one with a loss, solely for tax reasons. , tax-loss harvesting can be a useful part of your overall financial planning and investing strategy as long as it doesn’t lead to decisions that are ultimately in conflict with that strategy. (For more, see: When to Dump Portfolio Losers.)

INCREASED TAX RATES

Three key tax rates have increased this year:

• The top rate for long-term capital gains has increased to 20% from 15%.
• The new 3.8% Medicare surtax for high-income investors has made the highest effective capital gains tax rate rise to 23.8% for these taxpayers.
• The highest marginal rate for ordinary income has increased to 39.6% from 35%.

This potentially makes investment losses more valuable to higher income investors.

UNDERSTAND THE 'WASH SALE' RULE

The 'wash sale' rule says that if you sell an investment holding in order to recognize and deduct that loss for tax purposes you cannot then buy back that same asset or another investment asset that is “substantially identical” for 30 days following the sale. (For more, see: Tax-Loss Harvesting: Reduce Investment Losses.)

In the case of an individual stock this is pretty clear: If you had a loss in Exxon Mobil Corp. (XOM) and wanted to realize that loss you would have to wait 30 days before buying back into the stock if you wanted to own it again. This can actually be as much as 61 days because you need to wait at least 30 days from the initial purchase date to sell and realize the loss and then you need to wait at least 31 days before repurchasing that identical asset.

In the case of a mutual fund, if you realized a loss in the Vanguard 500 Index Fund (VFINX), you couldn’t buy the SPDR S&P 500 ETF (SPY), which invests in the identical index. You likely could buy the Vanguard Total Stock Market Index (VTSMX), though, as this fund tracks a different index.

Many investors use index funds and ETFs, as well as sector funds, to replace stocks sold in order to not violate the wash sale rule. This might work out for you but can backfire for any number of reasons, including extreme short-term gains in the substitute security purchased or if the stock or fund sold goes way up in price before you have a chance to buy it back. You should also be aware that the wash rule cannot be avoided by buying back the asset sold in another account, such as an IRA. (For more, see: Taking the Sting out of Investment Losses.)

PORTFOLIO REBALANCING

One of the best scenarios for tax-loss harvesting is if it can be done in the context of the normal rebalancing of your portfolio. As you look at which holdings to buy and sell torebalance, pay attention to cost basis.  This approach won’t cause you to sell solely to realize a tax loss that may or may not fit your investment strategy. (For more, see: Rebalance Your Portfolio to Stay on Track.)

A BIGGER TAX BILL DOWN THE ROAD?

Some financial advisers contend that consistent tax-loss harvesting with the intent to repurchase the sold asset after the waiting period dictated by the wash sale rule will ultimately drive your overall cost basis lower and result in a larger capital gain to be paid at some point in the future.

This could well be true on two counts: If the investment grows over time your gain can get larger. Also, we don’t know what will happen to the capital gains tax rates in the future. 

The flip side of this, however, is that the current tax savings might be worth enough to offset higher capital gains taxes down the road based on the concept of present value, which would say that a dollar of tax savings today is worth more than any additional tax to be paid later on. Clearly this will depend on a variety of factors. (For more, see: Does Tax Loss Harvesting Really Work?)

NOT ALL CAPITAL GAINS ARE CREATED EQUAL

Short-term capital gains are those realized from investments that you have owned for a year or less. They're taxed at your marginal tax rate for ordinary income. The top marginal tax rate on ordinary income was 39.6% in 2014. (For related reading, see: Capital Gains 101.)

Long-term capital gains are realized from investments held for over a year and are taxed at significantly lower rates. For many investors the rate on these gains is 15%, the highest rate being 20%. Remember that for the highest incomes, the additional 3.8% Medicare surtax comes into play here as well. (For related reading, see: Capital Losses and Tax.)

Losses of a given type are first supposed to be offset against first against gains of the same type for example long-term gains against long-term losses. If there aren’t enough long-term gains to offset all of the long-term losses then the rest of the long-term losses could be used to offset short-term gains and vice versa. If there are still losses left then up to $3,000 in investment losses can be deducted against other income in a given tax year with the rest being carried over to subsequent years.

Certainly one of the considerations in the tax-loss harvesting decision in a given year is the nature of your gains and losses. You'll want to analyze this prior to moving forward. 

MUTUAL FUND DISTRIBUTIONS

With the stock market gains of the past few years many mutual funds have been throwing off sizable distributions, some of which are in the form of both long and short-term capital gains. These distributions also should factor into the equation.

LOOK AT THE BIG PICTURE

Tax-loss harvesting is but one tactic that can be used on the path toward achieving your financial goals. In order to determine if this is a good idea for you step back and first look at your overall tax situation.

THE BOTTOM LINE

While it is a good idea to review your portfolio for tax-loss harvesting opportunities at least annually, whether or not to move forward should be evaluated in the overall context of your tax situation and whether or not these transactions fit with your overall investing strategy. Tax reduction is a strategy and not an end unto itself. Make sure to consult with a financial advisor or tax professional knowledgeable in this area. (For more, see: 7 Year-End Tax Planning Strategies.)

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.

IRS Warns Tax Return Preparers About Schedule C Errors

Ken Berry for CPA Practice Advisor writes: According to a new report in the Kiplinger Tax Letter, the IRS has mailed out more than 2,500 letters this month to tax return preparers who have been guilty of foiling a faulty Schedule C, Profit or Loss from Business (Sole Proprietorship). The gist of the message: Do better next time.

However, while the IRS appears to treating wayward practitioners with kid gloves for the time being, don’t expect examiners to be as lenient during the 2015 tax-filing season. Repeat offenders could be slapped with penalties for as much as $5,000 per return.

This isn’t the first time the IRS has addressed this issue. After sending out tens of thousands of such letters in the past, the IRS updated its posting of Letter 5105 on November 24, 2014. In the letter, Carolyn Campbell, Director of the Return Preparer Office, outlines the reason for the correspondence. It says that the IRS has reviewed tax returns the recipient prepared in the past year and discovered many have a high percentage of traits typically resulting in errors on Schedule C. The letter reminds tax professionals of their responsibilities and stresses the need for continued educational assistance.

Specifically, Letter 5105 covers the following:

Due diligence: A paid tax return preparer must take numerous steps to prepare accurate tax returns on behalf of his or her clients. Due diligence and includes reviewing the applicable tax law to establish the relevance and reasonableness of income, credits, expenses and deductions on a return. Generally, you can rely in good faith without verification on information provided by a client, but you can’t ignore the implication of the information you have. Make reasonable inquiries if the information appears to be incorrect, inconsistent or incomplete. [snip]  The article continues @ CPA Practice Advisor, click here to continue reading....