I recently received an interesting request from a client that I thought I would share, as I think it allows for some good insight into the tax impact of capital gains and losses, a topic that straddles investing and tax management. The request that I received was relayed from an accountant who suggested that, because the client had accumulated some loss carryforwards, some capital gains should be realized, as a means of “using up” capital losses that had been “banked”.
Tax strategies can often get complex, especially when it comes to capital gains and losses. Regardless of whether triggering capital gains to offset capital losses seems intuitive, this approach might not be as advantageous as it could potentially appear. Let's delve into why this might not be the optimal financial strategy.
Understanding Capital Gains and Losses
When are we taxed?
In terms of tax consequences, most of you probably interpret a gain in capital intuitively as being akin to, if not the very definition of, acquiring income. Part of the reason for this is most likely due to our tax system relying predominantly on what is gained in a transaction as the basis for when taxes are levied. In other words, it is probably fair to say that we are conditioned to understand that when we receive something of financial benefit, particularly in the form of money, we will owe a portion of that gain to Caesar.
As disgruntled as we might be about having to pay taxes, the reality is that we typically don’t pay taxes unless we have experienced an increase in our wealth. So, one way to look at taxes on capital gains is that it’s the cost of doing business. Instead of keeping 100% of what you have gained, you might keep 85%, as an example, if capital gains taxes apply.
The tax benefit of realizing investment losses
Conversely, if wealth is lost in a transaction, particularly in the form of a capital loss, we might be tempted to stop short in our thinking and only see a loss as a purely negative event—i.e., there’s no benefit. While the bad might indeed outweigh the good, our tax system does allow for redemption, so to speak, when it comes to capital losses, because they can be used to offset income, thus reducing the corresponding tax liability. Generally speaking, capital losses can offset capital gains to an unlimited extent but can only be used to offset $3,000 of ordinary income annually.
The cap on offsetting ordinary income, coupled with a relative lack of capital gains to offset, is precisely how loss carryforwards are created. If you could offset an unlimited amount of ordinary income, then you would be able to exhaust any and all capital losses that might be realized in any given year. Since that is not the case, however, we are allowed, or required, to apply those losses against future income.
As I alluded to above, the benefit gained through applying capital losses against income might not exceed, or even equal, the negative impact to wealth that results from a loss, but a benefit still exists, nonetheless. The reason why it is important to acknowledge that simple fact is because if something is a benefit to us, then that means that it is a resource, just like any other, and should be applied and administered accordingly. This is also why the strategy of harvesting tax losses, whereby positions are sold expressly for the purpose of realizing losses, exists in the world of investing and tax management.
Is Tax Gain Harvesting a Thing?
To some, it might seem logical to conclude that if loss harvesting is a strategy then gain harvesting might be as well. In exploring any potential advantages and disadvantages, a good place to start might be this simple question: suppose you had two investments, one performing poorly and one performing well, which one are you more likely to sell? On its face, it would seem that divesting from something that has served you well would be counterintuitive, particularly if no reason existed to think that future performance would be any different.
That being said, we don't live in a vacuum, so there could be a factor that sits outside of performance that might change our perspective. Specifically, it would have to be something that presents the opportunity for some kind of benefit.
In addition to the tax benefits of selling a loss position, there are two other potential benefits of doing so:
1) Offloading of risk of any further poor performance.
2) Opportunity to reposition funds in a superior investment.
Conversely, realizing a gain of a position, for no other reason than to realize the gain, doesn’t seem to offer benefits on par with that of realizing a loss, at least not immediately. The reasons for that are basically the exact opposite of the advantages associated with realizing losses:
- You lose the opportunity to benefit from any additional positive performance.
- Wash-sale rule: disallows claiming a loss on a security if you buy a "substantially identical" security within 30 days before or after the sale. As a consequence, you might end up repositioning your funds in an inferior investment.
- You potentially increase taxable income, assuming no loss carryforwards, which would just seem to elicit the essential question this post is intended to explore: why would it be beneficial to hastily exhaust loss carryforwards?
- Because short-term capital gains, which result from the sell of gain positions held for less than a year, are taxed at ordinary income rates, there is a risk of paying a higher tax rate on those gains, if the gains are in excess of any losses that could potentially be used as an offset.
- This would be true, in particular, if the total amount of taxable ordinary income to be reported exceeds the upper limit of what is now the 12% federal tax bracket.
To be clear, it can't be said that it is never advantageous to purposefully offset loss carryforwards by manufacturing gains. One example would be if a position in an investment had been maintained expressly because of the gain that would be realized from its sell. If an investor found him/herself in such a position with a healthy amount of loss carryforwards, then it might behoove the investor to go ahead and sell the position, because of the reduced tax liability from applying the capital losses against the gain. At the risk of stating the obvious, though, that is typically a rare and unique situation.
A Better Approach
Instead of artificially realizing gains:
Strategic Tax-Loss Harvesting: Use losses to offset gains naturally occurring in your investment strategy, without forcing sales. This can be done at year-end when you review your portfolio's performance.
Long-term Investment Strategy: Focus on long-term growth rather than short-term tax benefits. This might mean holding onto winning investments longer, benefiting from lower capital gains tax rates.
Diversification: Maintain a well-diversified portfolio to naturally balance gains and losses over time without the need for forced sales.
In conclusion. while the idea of using up capital losses by realizing gains might seem like a clever tax strategy, the potential downsides in terms of market timing, increased tax rates, and opportunity costs often outweigh the benefits. A more thoughtful approach to investment and tax strategy, focusing on long-term financial health, is generally more beneficial.