By Raoul Rodriguez
In my last article, I showed you how to calculate gains and losses on the sale of securities purchased on a stock exchange. I wish I could say that there are always gains! But, alas, losses are also part of investing. Much has been written over the years regarding how to use realized losses to mitigate taxes, but there are limits to the strategy.
As a U.S. person, if you have investments in a taxable brokerage account, you can strategically sell the position to realize the loss, with the intention of using the loss to offset other gains or bank the loss for use at some future date. This practice is called “tax loss harvesting.” If you like the investment you sold to generate the loss, you can repurchase the same security some weeks later. This may seem like a good strategy initially, but on closer examination, its benefits are limited. Let us see an example to understand why.
Let’s assume you own Tesla (TSLA). You purchased TSLA at US$200 a few years ago, and let us also assume that price is your adjusted costs basis. The stock is currently trading at US$160. You also have a mutual fund that has distributed long-term capital gains this year for US$40. You don’t want to pay tax on the mutual fund distribution, so you decide to sell TSLA, realizing a loss of US$40 to offset the mutual fund gains, for net gain of 0. Assuming a capital gains tax rate of 20% your capital gains tax savings are US$8 (US$40 x 20%).
You are a big fan of Elon Musk so repurchase TSLA after one month at the same US$160. Your new adjusted cost basis is US$160. Any sell transaction above this price will result in a gain, which in this case is called the “recovery gain.” You wait a couple of years and sell TESLA at US$200. The cost basis is US$160, and you sold at US$200 for a gain of US$40. Assuming you are still in the same capital gains tax bracket, the tax on this transaction is also US$8. Note you are in the same position as if you had not sold the stock in the first place! Seen another way, you now need to pay back the US$8 you originally saved when you first sold TSLA.
Understand this as an interest free loan that needs to be paid back when you eventually sell the security. While there is value in the fact that you had an extra US$8 in tax savings to use for a couple of years, to truly benefit financially from the transaction, you would need to have invested the tax savings.
If you are subject to the same capital gains tax rate over time, the benefits of tax loss harvesting are relatively minor. While tax loss harvesting may generally not be of much benefit to many U.S. taxpayers, there are some exceptions. For example, if you have accumulated incentive stock options that will be exercised in the future, and which will generate a lot of taxable gains, it may be beneficial to have banked losses over time. Also, there is an opportunity for some taxpayers to engage in what is known as “tax bracket arbitrage.”
Deduction Against Ordinary Income
You can deduct up to US$3,000 of capital losses against other ordinary income. U.S. taxpayers in higher tax brackets benefit the most from this deduction because some income, which otherwise would be taxed at higher ordinary rates, escapes tax all together. Since the maximum loss that can be deducted is US$3,000 per year, the largest tax benefit would be for those in the 37% bracket, for a maximum tax income savings of US$1,110 per year.
When you are in the “Magic Window”
Recall that I mentioned above that tax loss harvesting is less beneficial if your capital gains tax rate remains the same over time. However, there may be times in your life when your capital gains tax bracket goes down. For many U.S. taxpayers, this often happens in the years right after retirement, when income from wages or the sale of a business are no more, but prior to the years when Social Security (which can be postponed up to age 70) and Required Minimum Distributions from qualified plans and IRAs (which at present can be postponed to age 72) kick in. I call this period the “magic window” because there are several planning opportunities that present themselves for a relatively brief period. One of these happens when you offset recovery gains while in the magic window against accumulated losses realized prior to retirement. Let us continue with our prior example. Assume you originally sold TSLA at US$160 as described previously and saved US$8 in capital gains taxes by implementing a tax loss harvesting strategy. You still repurchased TSLA, but now let us assume that you postpone realizing any recovery gains until you are in the magic widow when your capital gains tax rate has gone down from 20% to 15%. When you sell at US$200, your tax on the US$40 gain is only US$6 (USD$40 x 15%), and now you do realize a tax savings of US$2.
When is tax Loss harvesting a “No-No”
If you are in the 0% capital gains tax bracket, there is no value in harvesting losses. In fact, in this case it is best to harvest gains, thus increasing cost basis and possibly lowering tax costs in the future if your capital gains bracket goes up!
Those in the 10% or 12% income tax brackets could be worse off if they are caught in the 15% capital gains bracket or higher, creating negative value of at least -5% and -3%, respectively, if not careful!
From a Mexican tax perspective, largely because we are dealing with a flat tax of 10% on the sale of securities on the stock exchange, there is a small benefit to the degree that you can defer taxes and invest the initial tax savings. Further, since any losses can be carried forward only for 10 years (unlike the U.S., where you can carry losses forward indefinitely), you also risk losing the tax deferral benefit if your timing is off.
In sum, the strategy of tax loss harvesting is generally misunderstood and can even hurt some taxpayers. In certain circumstances this strategy can be beneficial, but careful analysis needs to be considered. Don’t forget that a loss in Mexico might be a gain in the U.S. and vice versa, further complicating the analysis for those that pay tax in both countries. Please consult with your tax advisor.
My next article will be less technical, discussing why U.S. persons would be well served to avoid investing in any foreign mutual funds.
