Your Unopened Gift From the IRS
As the holiday season comes and goes, there is one gift many Americans forget to open: tax savings in their brokerage accounts.
Taxes come in many shiny packages (income, sales, capital gains, property, estate, etc.
), and while some are hard to avoid, others can be easily minimized.
Sure many of us have made tax deductible donations throughout the year that have helped our favorite charities and lowered our taxable income, but only a few of us have harvested losses.
Tax loss harvesting, if executed properly, is a powerful technique used to significantly lower one's taxable income and hence their taxes.
It is the act of intentionally selling an investment at a loss to offset current and/or future capital gains.
Of course we all prefer to see our stock portfolios rise in value, even if that means having to pay tax on capital gains.
But as we have painfully witnessed in 2007 and 2008, portfolios can also incur losses.
While no one likes to see their investments go down in value, savvy investors can capitalize on such losses or do as the old saying goes, "when life gives you lemons, make lemonade.
" Current IRS rules limit capital loss deductions to $3,000, but losses greater than $3,000 can be carried over and used in future years.
For example, assume you purchased an investment for $20,000 and sold it for $10,000, you can only deduct $3,000 each year from your taxable income.
The remaining $7,000 would carry over to future years to offset future capital gains.
So if the following year you sold another investment for a $15,000 capital gain, you would pay tax on only $8,000 ($15,000 - $7,000).
Tax loss harvesting is when an investor intentionally sells an asset (even if you still like the asset) to recognize and bank (harvest) a loss for future use.
Here is how it works.
Assume you bought investments in 2007 worth $100,000, but they are now worth $60,000.
You initially purchased the investments for long term growth and have no intention of selling them because the investment still helps meet your long term goals.
While you have a 40 percent loss, the loss is unrecognized because you have not sold anything.
However, if you tax loss harvest, you would sell your investments now, realize a $40,000 loss which you can save to offset future capital gains, and repurchase your investments.
Your investments would still be worth $60,000, but now you have lemonade you can drink for years to come.
You are still only limited to $3,000 per year in losses as discussed above, but now you have $40,000 in losses you can save and use to off-set any future capital gains for multiple years, that only expire upon death.
So let's assume you had no other sales for the next few years and then after 5 years, you sell a rental property for a $50,000 gain, you can use the $40,000 loss to off-set that gain and only pay tax on $10,000.
This will substantially decrease your taxes.
As with everything, the IRS has rules and limitation.
The IRS wash-sale rule states that if you sell an investment to recognize a loss, you cannot buy another "substantially identical security" within 30 days.
So for instance, if you sold State Street S&P 500 SPDRs (ticker: SPY), you cannot replace it with the iShares S&P 500 Index (ticker: IVV) because they both own essentially the same investments.
However, you can purchase a temporary investment that is not essentially same, but is very highly correlated.
Using the same example, you could sell the SPY to recognize a loss and purchase the iShares Russell 1000 Value Index (ticker: IWD) as its replacement.
The two assets are not essentially the same, but they both highly correlated and tend to move in tandem.
2009 will remain a monumental year for many reasons, but as the market tested historic lows on March 9th and staged a thunderous rebound, many of us are sitting on either large unrealized gains, losses, or both.
This year, give yourself the gift that keeps on giving for years to come - harvest your losses; if done properly, you could avoid paying taxes on capital gains for years.
Of course tax loss harvesting is only relevant in your taxable accounts and not in your IRAs, 401ks, or other tax efficient investment vehicles.
Each person's tax situation is different so investors should consult with their financial and tax advisors before engaging in such strategies.
Taxes come in many shiny packages (income, sales, capital gains, property, estate, etc.
), and while some are hard to avoid, others can be easily minimized.
Sure many of us have made tax deductible donations throughout the year that have helped our favorite charities and lowered our taxable income, but only a few of us have harvested losses.
Tax loss harvesting, if executed properly, is a powerful technique used to significantly lower one's taxable income and hence their taxes.
It is the act of intentionally selling an investment at a loss to offset current and/or future capital gains.
Of course we all prefer to see our stock portfolios rise in value, even if that means having to pay tax on capital gains.
But as we have painfully witnessed in 2007 and 2008, portfolios can also incur losses.
While no one likes to see their investments go down in value, savvy investors can capitalize on such losses or do as the old saying goes, "when life gives you lemons, make lemonade.
" Current IRS rules limit capital loss deductions to $3,000, but losses greater than $3,000 can be carried over and used in future years.
For example, assume you purchased an investment for $20,000 and sold it for $10,000, you can only deduct $3,000 each year from your taxable income.
The remaining $7,000 would carry over to future years to offset future capital gains.
So if the following year you sold another investment for a $15,000 capital gain, you would pay tax on only $8,000 ($15,000 - $7,000).
Tax loss harvesting is when an investor intentionally sells an asset (even if you still like the asset) to recognize and bank (harvest) a loss for future use.
Here is how it works.
Assume you bought investments in 2007 worth $100,000, but they are now worth $60,000.
You initially purchased the investments for long term growth and have no intention of selling them because the investment still helps meet your long term goals.
While you have a 40 percent loss, the loss is unrecognized because you have not sold anything.
However, if you tax loss harvest, you would sell your investments now, realize a $40,000 loss which you can save to offset future capital gains, and repurchase your investments.
Your investments would still be worth $60,000, but now you have lemonade you can drink for years to come.
You are still only limited to $3,000 per year in losses as discussed above, but now you have $40,000 in losses you can save and use to off-set any future capital gains for multiple years, that only expire upon death.
So let's assume you had no other sales for the next few years and then after 5 years, you sell a rental property for a $50,000 gain, you can use the $40,000 loss to off-set that gain and only pay tax on $10,000.
This will substantially decrease your taxes.
As with everything, the IRS has rules and limitation.
The IRS wash-sale rule states that if you sell an investment to recognize a loss, you cannot buy another "substantially identical security" within 30 days.
So for instance, if you sold State Street S&P 500 SPDRs (ticker: SPY), you cannot replace it with the iShares S&P 500 Index (ticker: IVV) because they both own essentially the same investments.
However, you can purchase a temporary investment that is not essentially same, but is very highly correlated.
Using the same example, you could sell the SPY to recognize a loss and purchase the iShares Russell 1000 Value Index (ticker: IWD) as its replacement.
The two assets are not essentially the same, but they both highly correlated and tend to move in tandem.
2009 will remain a monumental year for many reasons, but as the market tested historic lows on March 9th and staged a thunderous rebound, many of us are sitting on either large unrealized gains, losses, or both.
This year, give yourself the gift that keeps on giving for years to come - harvest your losses; if done properly, you could avoid paying taxes on capital gains for years.
Of course tax loss harvesting is only relevant in your taxable accounts and not in your IRAs, 401ks, or other tax efficient investment vehicles.
Each person's tax situation is different so investors should consult with their financial and tax advisors before engaging in such strategies.
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