Though the markets have been up strongly this year, your investment portfolio could have a few lemons in it. Using the tax strategy of tax-loss harvesting, you may be able to turn those lemons into lemonade. Here are five tips:
Tip #1: Separate short-term and long-term
Your investments are divided into short-term and long-term buckets. Short-term investments are those you've held a year or less, and their gains are taxed as ordinary income. Long-term investments are those you've held more than a year, and their gains are taxed at generally, lower capital gains tax rates. A goal in tax-loss harvesting is to use losses to reduce short-term gains.
Example: By selling stock in Alpha Inc., Sly Stocksale made a $10,000 profit. Sly only owned Alpha Inc. for six months, so his gain will be taxed at his ordinary income tax rate of 35 percent (versus 20 percent had he owned the stock more than a year). Sly looks into his portfolio and decides to sell another stock for a $10,000 loss, which he can apply against his Alpha Inc. short-term gain.
Tip #2: Follow netting rules
When tax-loss harvesting, use IRS netting rules on the realized gains and losses in your portfolio. Short-term losses must first offset short-term gains, while long-term losses offset long-term gains. Only after you net out each category can you use excess losses to offset other gains. Use this knowledge to your advantage to reduce your taxable income when selling investments.
Tip #3: Lower your ordinary income by $3,000
In addition to reducing capital gains tax, excess losses can also be used to offset up to $3,000 of ordinary income each year. If you still have excess losses after reducing both capital gains and ordinary income, you can carry these losses forward to use in future tax years.
Tip #4: Beware of wash sales
The IRS prohibits use of tax-loss harvesting if you buy a "substantially similar" asset within 30 days before or after selling it. Plan your sales and purchases to avoid this problem.
Tip #5: Consider administrative costs
Tax-loss harvesting comes with costs in both transaction fees and time spent. Reduce the hassle by conducting tax-loss harvesting once a year as part of your annual tax-planning strategy.
Remember, you can turn an investment loss into a tax advantage, but only if you know the rules.