With the major stock market indices in bear market territory, this may be a good time to evaluate the potential benefits of realizing some capital losses in the investment portfolio. No one enjoys admitting defeat by selling an asset that has gone down in value, but that capital loss may be netted against realized capital gains to lower the overall tax bill. What’s more, up to $3,000 worth of capital losses may be subtracted from ordinary income if total losses exceed total capital gains. Unused capital losses may be carried forward indefinitely.

Mature couple smiling at each other

Example One — Jack owns two blocks of shares of XYZ Corp., 100 shares each. The first block was purchased for $20,000 ten years ago, the second block for $60,000 two years ago. Each block is worth $40,000 today. Selling the first block would trigger a $20,000 long-term capital gain and a $4,000 tax bill for Jack. Selling the second block would create a $20,000 long-term capital loss. If Jack sells both blocks, the loss offsets the gain and there is no tax liability. The full $80,000 of proceeds is available for reinvestment.

However, it should be understood that although Jack has successfully deferred taxes into the future, he has not reduced his ultimate tax obligation. Jack’s tax basis in a new investment will be $80,000, the same as his basis in XYZ Corp. If the new investment does well, tax will be due on those capital gains when it is sold. If Jack is then in a higher tax bracket, or if Congress has raised the tax rates, it is possible he would be worse off for having harvested the loss.

Therefore, tax loss harvesting is not necessarily a good idea for everyone, but should be undertaken only with professional supervision.

Watch out for “wash sales.”

To avoid gaming the system, the tax code does not permit claiming a capital loss for a sale if the same or a “substantially identical” security is purchased by the taxpayer either 30 days before or after the sale. One cannot sell on day one to lock in a loss and then buy back the same shares on day two. The risk of being out of the market for 30 days must be incurred, and in today’s volatile markets that risk can be large. Hence, one should generally book losses on shares one no longer wants to own.

Unfortunately, the IRS has been vague about the meaning of “substantially identical,” and there is plenty of grey area in that phrase. Selling one actively managed mutual fund and buying a different fund should not present a problem, even if some of their underlying holdings overlap. But what about selling an S&P 500 index fund from one company and buying the same type of index fund from another company? That would appear to violate the spirit of the law.

Loss harvesting is something to be done in taxable accounts, as there are no losses to be harvested in tax-deferred accounts such as IRAs. However, the IRAs do come into play in the wash sale rules.

Example Two — Jacks sells 100 shares of XYZ Corp. at a $20,000 long-term loss. Two weeks later, he directs his IRA custodian to purchase 100 shares of XYZ Corp. for his IRA. The wash sale rule has been triggered, so the capital loss will not be allowed. All accounts under the same Social Security number are aggregated for this test. If Jack is married and the couple files jointly, purchases by Jack’s wife will also be considered for the wash sale rules, whether in her IRA or a separate brokerage account.

Ultimately, issues of asset allocation, time horizons, economic outlook, and interest rate risk will have a greater impact on portfolio performance than tax considerations. Still, in the right circumstances, tax loss harvesting can be a worthwhile strategy to evaluate.

Is there more to explore?

These ideas are just the beginning, intended solely to simulate your thinking.

Arvest Wealth Management does not provide tax advice, so be sure to consult with your tax professional before taking any action. He or she can fill in those important details. Turn to Arvest Wealth Management for answers to your investment and financial management questions. Put our experience to work for you!

This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.

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