Make the IRS chip in for your roller-coaster ride.
Investors, you just dodged a bullet.
I’m not talking about the crash, of which the Feb. 5 escapade may be nothing but a foretaste. I’m talking about a tax maneuver you can use to soften the blow of bear markets. The Republicans were threatening to damage this technique, but backed down at the last minute in their December tax law.
You can hire a pro to generate the tax saving, but you don’t have to. The recipe that follows will enable you to do this safely at home. Either way, though, use the technique while you still can. A future Congress could resume the assault on investors.
The problem that needs solving is this: You want to capture losses in your portfolio but don’t want to miss out on a rebound. This gets tricky, because of a century-old rule on “wash sales.”
Say you got into General Electric at $30 and it’s now trading at $15. If you sell in order to claim the $15 loss on your tax return, you can’t get right back into the stock. The purchase of the same stock within 30 days before or after the sale makes the sale into a wash and invalidates your capital loss deduction.
What to do? You could sell GE at a loss, then hold your breath and buy replacement shares 31 days later. But if the market rebounds during that time your tax trade will have made you poorer.
My solution is what I’ll call stochastic loss harvesting. It works best if you have a freshly created, widely diversified portfolio—say, 40 positions. It doesn’t give you ironclad protection against being whipsawed, but it greatly reduces the risk of serious damage.
Eleven months after buying these 40 stocks, examine your brokerage statement. In a ridiculously bullish market (such as we had until last week), perhaps all 40 are winners. But a more likely outcome is that you have a bunch of stocks that are under water.
Select 8 of these losers. Call them A, B, C, D, E, F, G, H, ordering them so that the first four positions are worth about the same as the last four.
Sell A through D and use the proceeds to double up your positions in E through H. Wait 31 days. Then sell the old positions in E through H, using the proceeds to reestablish your original stakes in A through D.
What if the stock market goes down during your month of transitioning? Getting back into A through D will cost you less than what you realized on their sale, but you’ll (probably) have a corresponding loss on the extra shares of E through H. When the dust settles your brokerage statement is about where it would have been had you stood pat the whole time, but you now have 8 capital losses to claim on your tax return.
And if the market goes up during the month? Again, you’re close to where you would have been standing pat, but you’ve got at least 4 capital losses to claim. If the market goes sideways for the month you will have 8 losses on your tax return.
There’s some risk. The fancy footwork will leave you poorer if E through H underperform A through D during the month. It’s equally likely, though, that E through H will outperform, dealing you a windfall gain. Either way, the law of averages says that your tracking error is likely to be small in relation to the amount of capital in play.
A version of the tax bill on the table last fall would have damaged traders by removing their right to specify which lots are being sold when they sell part of a position. They would have had to use first-in-first-out accounting. In our example, you would have gotten tripped up if you had older, low-cost positions in any of the targeted stocks.
Take a look at your taxable portfolio, and take a close look if you have more than one purchase lot in any stock. Among the stocks that could be candidates for loss harvesting if a lot was acquired within the past year are these, all down at least a third from their highs: General Electric (GE), Allergan (AGN), Regeneron Pharmaceuticals (RGN), PG&E (PCG) and CenturyLink (CTL).
What can you do with a capital loss? You can use it to absorb any amount of capital gain thrown your way (from, say, cap gain distributions by funds or the sale of a vacation home) plus up to $3,000 a year of ordinary income. Unused losses can be carried forward indefinitely.
Keep an eye on transaction costs. With a $1 million portfolio containing 40 positions, each round-trip trade would capture the loss on one $25,000 position cost-effectively. With a $100,000 portfolio you might need to find a commission-free trading offer for the game to be compelling.
Professional loss harvesting is available at roboadvisors. These guys can glean more losses than you could, but their fees (typically, 0.25% of assets annually) drain away a significant fraction of the potential tax benefit.
Originally published at Forbes