As the trees of New England shed their verdant hue for the spectacular colors of autumn, farmers begin to harvest summer's bounty. With the markets shedding trillions in market capitalization over the past three years, mutual fund investors find themselves sitting on a bumper crop of unrealized losses. Advisors should begin evaluating whether now is the time to harvest those losses through systematic tax-loss selling. While no one invests to lose money, loss is one of the natural byproducts of the risk-reward system that drives the capital markets. Knowing how and when to take those losses for the overall benefit of a client is an essential element to managing a client's wealth.
In broad terms, tax-loss selling is the matching of investment losses against investment gains for the overall financial betterment of the client. More specifically, it is the matching of ordinary income against ordinary losses and capital gains against capital losses to improve a client's net, after-tax return on investment. Tax-loss selling is not an end in itself, but rather a strategy employed alongside the investment process to secure the best after-tax financial outcome.
Financial advisors and their clients don't invest in a perfect world; rather, they are subject to various systemic frictions that can inhibit their ability to maintain and accumulate wealth. These include inflation, fees, transaction costs, currency fluctuations, and taxes. And while the impact of most of these friction points is well documented, the impact of taxes on capital accumulation, particularly within mutual funds, has largely been disregarded. It took an act of Congress in 2000 and increased regulation by the Securities and Exchange Commission to allow sufficient light to shine on the cost of taxes to mutual fund investors, which averages between one and two percent annually. Proper tax planning strategies, including tax-loss selling, can mitigate and sometimes eliminate that friction point.
Under existing tax code, all losses are not created equal. There is instead a hierarchy of utilization. First you need to match any long-term capital loss against long-term capital gain and any short-term capital loss against short-term capital gain. If there is any loss left over, you must then offset against the other type of capital gain. If there is any remaining loss, you can offset up to $3,000 in ordinary income. Any leftover loss can be carried over to the next year (see chart on page 62).
But it is not as simple as just matching up the right types of losses. Certain transactions, called "wash sales," are considered verboten by the IRS. Simply defined, a wash sale is the sale of stock or other securities (including mutual funds) closely preceded or followed by the acquisition of the "substantially same" stock or security. Any loss generated by the transaction will be disallowed. Determining if a transaction will be disqualified by the wash sale rules is a two-part test. Part one is determining the wash sale period; it consists of the day of the sale, plus the 30 days prior, plus the 30 days following the sale.
By way of example, consider John Smith. If Mr. Smith sells 100 shares of XYZ fund on December 31, 2002, generating a capital loss, and then buys back 100 shares in the same fund on January 15, 2003, the loss is disqualified as a wash sale
If Mr. Smith owns 100 shares of XYZ fund on December 1, 2002, and buys an additional 100 shares of XYZ on December 1, 2002, and then sells his original 100 shares on January 1, 2003, this transaction likewise violates the wash sale period and the loss would be disqualified. (For the purpose of wash sale rules, purchases made through capital gains and dividend reinvestment can also disqualify a sale.)
Part two of the wash sale equation is determining if you are acquiring "substantially identical" securities. In the case of individual stocks or bonds it's pretty clearcut. But when selling and buying different but similar mutual funds, the water gets muddy. For example, the sale of XYZ Mutual Fund Company's S&P 500 Index fund and the purchase of ABC Mutual Fund Company's S&P 500 Index fund within the disqualifying period could be challenged by the IRS. So caution dictates carefully evaluating fund holdings to avoid this trap.
But can a client really benefit from a loss? Absolutely. Not because losing money is the goal, but because once it happens, harvesting the loss may be the right investment decision anyway. That action may also provide an opportunity to reduce a client's taxes that–but for the offset–would reduce accumulated wealth or income or both. The best way to illustrate this is by way of another example. Let's look at three situations, each with and without loss harvesting.
Example I: Mom's House & Funds
Mom is 84 years old, widowed, and at the stage of her life where she needs to sell her home and move into a nursing home. Aside from the house, valued at $685,000, her other source of net worth is a portfolio of mutual funds, primarily growth funds, which is managed by her son and is worth $420,000 today but started out as being worth $800,000 three years ago when her husband died.
Scenario one: No loss selling Mom's house is sold in November 2002. The sale price is $685,000, less a 5% sales commission of $34,250, less a cost basis of $100,000, less primary residence deduction of $250,000, all of which results in taxable net proceeds of $300,750. The 20% long-term capital gains federal tax due in 2002 on the home's sale would be $60,150. In January 2003, tired of the market's gyrations, the son sells the funds and puts the proceeds in a money market fund.
Scenario two: Loss selling Exact same set of facts as scenario one except that the son, with an advisor's guidance, sells the growth funds in 2002 and repositions in a more conservative asset allocation. Net long-term capital loss on the sale of the funds is $380,000. She has net tax savings of $60,150 on the sale of the home, plus an additional $3,000 deduction against ordinary income in 2002, with the remainder carried forward into the following year(s).
Using proper loss harvesting, the advisor generated an additional $60,150 in net proceeds on the home's sale. If she were your mother, wouldn't you want that advice?
Example II: Dwindling Inheritance
