The economics of tax-loss harvesting.

• Author: Fleming, Lincoln

Tax-loss harvesting is a popular investment strategy that seeks to obtain a tax benefit from the sale of securities that have declined in value. It is an intricate, nuanced strategy that may provide tremendous tax benefits to some investors but is not appropriate in all situations. Understanding the context and mechanics of loss harvesting can help advisers identify suitable candidates and circumstances for its use.

Why harvest losses?

U.S. federal income tax law allows capital losses to offset capital gains and limited amounts of ordinary income that would otherwise be taxable to investors. Consequently, the methodical realization of capital losses by selling securities that have declined in value has become a tax management staple for many investors. The goal of tax-loss harvesting is not to invest in securities that will decline in value but rather to improve after-tax returns by taking advantage of market volatility.

Which investors stand to benefit from tax-loss harvesting?

For tax-loss harvesting to be beneficial, it must be effectuated in taxable accounts, and investors must have sufficient capital gains or other income available to absorb the realized losses. Capital losses may offset capital gains and up to $3,000 of ordinary income on the federal income tax return of a noncorporate taxpayer. (1)

For assets held directly as individual securities in separately managed accounts or in flowthrough entities such as investment partnerships (e.g., private equity or hedge funds), both short- and long-term capital gains pass through to the investor's Schedule D, Capital Gains and Losses, where they can potentially be offset by capital losses from loss harvesting.

In contrast, not all capital gains distributed by open-end mutual funds, exchange-traded funds (ETFs), and other funds governed by the Investment Company Act of 1940 ('40 Act funds) flow to an investor's Schedule D. Long-term capital gain distributions maintain their character and flow to an investor's Schedule D; however, short-term capital gain distributions from '40 Act funds are treated as nonqualified dividend income to investors and thus are ineligible to be offset by capital losses on Schedule D.

Tax-loss harvesting as a specific strategy is typically offered through a separately managed account. While losses realized in '40 Act funds cannot be passed through to investors, losses harvested within separately managed accounts can flow through to investors and be used to offset capital gains generated from outside sources. Losses realized within certain flowthrough or disregarded entities, such as partnerships, S corporations, or certain trusts, may provide a similar benefit to the owners of these entities.

Some investors generally should avoid harvesting losses, including tax-exempt investors, investors with only tax-advantaged accounts (i.e., individual retirement arrangements (IRAs), health savings accounts, Sec. 529 plans, Sec. 401(k) plans, etc.), and investors without adequate capital gains or other income available to offset the losses. In certain situations, it may be beneficial for an investor to realize long-term capital gains rather than harvest losses. For example, realizing gains may be appropriate to achieve tax bracket management objectives, to manage risk, or to absorb expiring net operating losses.

Tax-loss harvesting reduces the basis of a portfolio

Financial literature tends to focus on the immediate tax savings from tax-loss harvesting but frequently neglects to consider its impact on the cost basis of the investment portfolio. While loss harvesting can provide valuable upfront tax savings, the cost basis of the portfolio is reduced over time by the amount of the realized losses. In other words, higher-basis tax lots are replaced with lower-basis tax lots, potentially causing offsetting capital gains to be realized in the event of a future liquidation.

Example: Consider a hypothetical investor who purchases security A for $10,000 and harvests a $3,000 loss when the price of the security declines to $7,000. The investor immediately reinvests the proceeds in security B, which is not substantially identical to security A but has similar risk and return characteristics (and for simplicity, assume future investment performance is identical for both securities in this example). The investor later sells security B after the price of the security increases to $10,000, realizing a $3,000 gain.

Had the investor not harvested the $3,000 loss, no capital gains would have been realized at final liquidation. In either scenario, capital gains and losses net to zero.

Sources of value of tax-loss harvesting

From the simplistic example above, it might appear that tax-loss harvesting does not add any value, since the capital gains realized at liquidation appear to negate any perceived tax benefits procured from the previously harvested losses. However, such a conclusion ignores three types of benefit:

* Permanent reduction of current tax liability;

* Tax-rate arbitrage; and

* Tax deferral.

Permanent reduction of current tax liability

Capital losses generate upfront tax savings as they offset capital gains that would otherwise be taxable. (2) Although tax-loss harvesting...