The equity markets have performed extremely well for many clients in 2021 — in some cases, the gains may have been surprising enough to motivate the client to cash out on investments at a significant gain without much planning or advice.
While that can be considered a positive development for many, it can also mean that many clients may be faced with a larger-than-anticipated year-end tax bill on unexpected capital gains. Clients have a few short days to take action to prevent a surprise tax hit from digging into their profits.
While tax loss harvesting strategies are old hat for many advisors and clients, implementing these strategies properly can gain new importance for clients who may have unexpected gains for 2021—and advisors should pay particular attention to clients who may have engaged in cryptocurrency trading during the year.
Capital Gains Taxes: The Basics
Many clients are familiar with experiencing a year-end capital gains tax bill. They've even come to expect it. However, 2021 was unique for a number of reasons — meaning that some clients could be faced with long-term capital gains tax liability for the first time ever.
Fluctuations in the cryptocurrency markets during the year may have prompted many investors to sell when cryptocurrency prices were at their peak. Because cryptocurrency is treated as property, those clients will be liable for capital gains taxes on their profits — and it's no longer possible for those clients to fly under the IRS's radar when it comes to reporting crypto gains.
Remember, tax loss harvesting strategies don't apply to traditional retirement accounts, like IRAs or 401(k)s, where the funds grow on a tax-deferred basis. Those distributions are subject to ordinary income tax upon withdrawal, not capital gains taxes.
Further, clients should remember the distinction between short-term and long-term capital gains. Long-term capital gains tax rates apply when the client has held the asset for one year or more. Long-term capital losses will offset long-term capital gains.
If the holding period is shorter, the rates will be taxed as short-term capital gains (which mirror ordinary income tax rates).
Tax Loss Harvesting Strategy
First and foremost, any tax loss harvesting strategy must be executed by Dec. 31 in order for the loss to offset 2021 gains. With the tax loss harvesting strategy, clients will want to pay attention to fluctuations in asset value. Selling a capital asset at a loss in a year when the client will also realize long-term capital gains can offset the capital gains tax liability.
To execute a tax loss harvesting strategy, clients simply sell capital assets that have fallen in value to offset their capital gains for the year. These clients should also note that they can use up to $3,000 in capital losses to offset ordinary income for the year.
Further, any disallowed capital losses can be carried forward to future years if they exceed the client's capital gains by more than $3,000.
As always, clients should be careful when selling an investment merely to offset capital gains. Some investments may make sense in the long term even if they've performed poorly in recent years. Those long-term payoffs are also an important issue when considering the client's long-term tax outlook.
