By Raoul Rodríguez
In the world of financial planning, there are many myths and half-truths. One of these is the power of selling securities to harvest losses for later use, an activity that typically takes place towards the end of the tax year. The truth is that tax loss harvesting is only marginally beneficial for most investors and can even be harmful for some. For U.S. persons, certainly, this activity should be undertaken judiciously. But before we can delve into the intricacies of tax loss harvesting, we first need to understand how gains and losses are calculated when selling a stock market investment.
A taxable gain will result if the adjusted cost basis (costo fiscal in Mexico), the cost of the security plus or minus certain items, is lower than the price you eventually sell the security for. A loss results if the adjusted cost basis is higher than the proceeds received from the sale. The mechanics are the same in both the U.S. and Mexico. However, the formula to determine the adjusted cost basis differs significantly between both countries. Becoming familiar with these differences is particularly important to U.S. persons who may invest in the Mexican stock exchange and file tax returns in both countries.
In order to encourage investment activity, Mexico and the U.S. tax the gains in the stock market at preferential rates. In Mexico, the current capital gains tax on the sale of securities is a flat 10%, regardless of your tax bracket and regardless of the holding period. In the U.S. short-term gains (defined as those being realized from selling investments held one year or less) are taxed at regular income tax rates (as high as 40.8% if you include the net investment income tax of 3.8%), whereas investments that have been held for more than one year are considered long-term and are taxed preferentially. Long-term capital gains rates are subject to different tax brackets from 0%, 15% and 20% and in some situations can also be subject to a 3.8% surcharge.
Any stock market losses in Mexico can only be offset against gains from the sale of other capital investments. If there are excess losses in a tax period, these can be carried forward for up to 10 years. U.S. taxpayers are also allowed to offset losses in the market against gains on the U.S tax return. The U.S. will further allow a deduction of no more than US$3,000 per year of any unused losses against other income, carrying forward any remainder indefinitely for use in future years.
In Mexico, the cost basis of the security is adjusted up for any commissions paid. In addition, the cost basis is adjusted up by an inflation factor covering the holding period. Further, there is an adjustment made for dividends paid. However, unlike the U.S. where the calculation is made at the level of each taxpayer, in Mexico the adjustment for dividends is done at a corporate level since some dividends can be paid from accounts with after-tax corporate earnings or conversely from pretax corporate accounts, which affect that taxability of the dividend in hands of the individual. And then the inflation factor is also applied to this dividend adjustment. Yes, its complicated.
From a U.S. perspective, the cost basis is likewise adjusted up by commissions paid and any dividends received are simply added to the cost basis. In the case where you are investing in a foreign security, for example in Mexico, you also need to consider the exchange rate at the time of purchase, when dividends are received and when the security is sold.
Let’s consider an example where a taxpayer that files in both countries purchases and sells a security in Mexico.
Assumptions
- Buy 200 shares of Coca-Cola Femsa (KOF) on the Mexican Stock Exchange @ 200 pesos each on Jan. 1, 2022
- Sell 200 shares of KOF on the Mexican Stock Exchange @ 300 pesos each on Dec. 31, 2024
- Inflation factor 1.16
- Value of peso on Jan. 1, 2022, was 20 pesos to the dollar
- Value of pesos on Dec. 31, 2024, was 40 pesos to the dollar
- No commissions are paid
- Dividends equivalent to US$2 are paid in 2022 and 2023 and US$3 in 2024
U.S. Calculation
The purchase value is 40,000 pesos (200 pesos x 200). The peso was trading at 20 pesos to the dollar on the date the security was purchased, so the original cost basis for U.S. purposes is US$2,000 dollars (40,000 pesos/20 pesos). Three dividend payments are made in pesos but in the U.S. dollar equivalent of US$2, US$2, and US$3 for a total of US$7. The adjusted cost basis for the securities at the end of 2024 for U.S. purposes is US$2,000 plus US$7 for a total of US$2,007.
The security is sold at 300 pesos a share at the end of 2024 for a total of 60,000 pesos (300 pesos x 200). Considering the exchange rate of 40 pesos to the dollar at the time, the U.S. dollar equivalent is US$1,500 (60,000 pesos/40 pesos).
The proceeds are deducted from the adjusted cost basis, expressed in dollars, to determine the realized loss of US$507 (US$1,500 – US$2,007).
Mexico Calculation
In Mexico the original costs basis of 40,000 pesos is adjusted by the inflation factor of 1.16 for a total of 46,400 pesos (40,000 pesos x 1.16). In addition, let us assume that the inflation adjusted dividend payments are equivalent to 203 pesos. The adjusted costs basis for Mexico is 46,400 pesos plus 203 pesos for a total of 46,603 pesos.
The realized amount upon sale was 60,000 pesos and thus there is a taxable gain of 13,397 pesos in Mexico, the difference between 60,000 pesos and 46,603 pesos.
Applying a 10% tax rate on this amount results in a tax of 1,339.70 pesos. Assuming an exchange rate of 40 pesos to the dollar, that would be equivalent to a capital gain tax in Mexico of US$33.49 dollars. You can apply the US$33.49 paid in Mexico as a foreign tax credit on your U.S. tax return.
Takeaways
Depending on the transaction amounts, the exchange rate at the time of different transactions, and inflation in Mexico, results will differ from the U.S. and Mexico. In other words, for tax purposes you could have a loss in Mexico and a gain to report in the U.S. or vias-versa.
Now that we know how to calculate gains and losses, we can review the strategy of tax loss harvesting, which will be the subject of my next article.
