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Despite a strong year for the stock market, you could still be sitting on portfolio losses. But you can leverage down assets to score a tax break, experts say.
The tactic, known as “tax-loss harvesting,” involves selling losing brokerage account assets to claim a loss. When you file your taxes, you can use those losses to offset portfolio gains. Once your investment losses exceed profits, you can use the excess to reduce regular income by up to $3,000 per year.
“Tax-loss harvesting is a tried and true strategy to lower investors’ tax bills,” said certified financial planner David Flores Wilson, managing partner at Sincerus Advisory in New York.
After offsetting $3,000 in regular income, investors can carry any additional losses forward into future years to offset capital gains or income.
“Investors can benefit substantially over time” by tax-loss harvesting consistently throughout the year, Wilson said.
What to know about the wash sale rule
Tax-loss harvesting can be simple when you’re eager to offload a losing asset. But it’s tricky when you still want exposure to that asset.
That’s because of guidelines from the IRS known as the “wash sale rule,” which blocks you from claiming the tax break on losses if you rebuy a “substantially identical” asset within the 30-day window before or after the sale.
In other words, you can’t sell a losing asset to claim a loss and then immediately repurchase the same investment.
How exchange-traded funds can help
While the wash sale rule is a challenge, exchange-traded funds, or ETFs, can help investors avoid trouble with the IRS, experts say.
“The beauty of using ETFs for doing tax-loss harvesting … is that there are so many similar, but not identical, ETFs that could be exchanged for a losing one,” said George Gagliardi, a CFP and founder of Coromandel Wealth Strategies in Lexington, Massachusetts.
For example, many ETFs in the same sector, such as large-cap value, emerging market or small-cap growth, use the same pool of stocks with different selection criteria, he said.
But ETFs with identical indexes, like the S&P 500, “will run afoul of the wash sale rule” and the loss won’t be allowed, Gagliardi said.
Ultimately, the IRS definition of “substantially identical” isn’t black and white and “depends on the facts and circumstances” of your case, according to the agency.
When in doubt, consider reviewing your plan with an advisor or tax professional to make sure you’re safe from violating the wash sale rule.