A series of strategies for tax-wise investors. Table of Contents.
A long-standing feature of the tax code is that gains and losses are recognized only on the sale of property. There are exceptions to the rule, such as for commodity futures, but they are not common.
We’re talking, of course, about what happens in taxable brokerage accounts; for tax-deferred savings this chapter is irrelevant.
Harvesting is the business of booking capital losses. Smart investors are happy to sell losers while hanging onto winners. If you have 40 stocks, 35 of them up from their purchase price and five down, you’d sell the five stinkers and replace them with similar but not identical investments (for example, you replace an oil stock with an index fund of oil stocks).
That harvesting gives you capital losses that can be used to absorb any amount of capital gains plus up to $3,000 a year of ordinary income. If you follow the rule of hanging onto winners you will avoid most capital gains, but you can’t avoid gains entirely. They occur as a result of cash mergers or distributions on mutual funds, so a pot of capital losses to draw on can be very valuable. Unused losses can be carried forward indefinitely.
Some money managers do this sort of thing on a grand scale, using computers for automated loss harvesting from giant portfolios that look like index funds. One of these outfits is Parametric Portfolio Associates, a Seattle firm that will become part of Morgan Stanley MS later this year in a merger.
MORE FOR YOU
Brian Longstraat, Parametric’s chief executive, says that automated harvesting can deliver a percentage point a year, or more, of incremental aftertax return during the first decade after a portfolio is created. (Just how valuable a capital loss deduction will be depends on what else is going on in your portfolio.) Eventually, the customer winds up with all positions in the gain column, so no further tax benefit can be extracted. But during that first decade the tax benefit is likely to amply cover the manager’s fee.
If you aren’t selling winners, what do you do with them? There are three clever things to do with them. You can give appreciated assets away to low-bracket a (see Shuffle Assets To Sidestep Capital Gain Taxes). You can leave them in your estate to benefit from the step-up. And you can donate them to a donor-advised fund for charities (see Bunch Your Donations To Get More Mileage Out Of Them).
One caveat about harvesting: Tax reformers are on the prowl, and there are various ways they could make this time-tested strategy less appealing.
One proposal on Capitol Hill is to tax investors on paper gains, the way commodity futures are now taxed. That would make harvesting irrelevant: All your losses would be automatically harvested every year, along with all your gains, and your tax bill would go way up.
What may chill that particular reform is the difficulty of implementing it. Would everybody have to get annual appraisals of their houses, business ventures and artwork? No? Maybe the paper-gain tax applies only to publicly traded securities. But then would it be fair to tax the widow who owns $20,000 of AT&T stock but give a pass to the owner of a privately held company worth $2 billion?
Another threatened tax change is to end the step-up in the basis of assets at death. That change might hit everyone, or, more plausibly, only families with assets worth millions. It might treat death as a sale, creating an immediate tax obligation, or it might merely have the heir pick up the old cost basis. The former approach seems unlikely, given that it would result in the forced sale of many an occupied house or Iowa corn farm.