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Tax loss harvesting is an investment strategy that allows investors to reduce their taxable income by selling investments at a loss to offset gains from other investments or even regular income. By strategically realising losses on underperforming assets, you can lower your tax bill and improve your portfolio’s after-tax return. Tax loss harvesting is particularly useful during market downturns and can be used to improve your portfolio’s long-term tax efficiency.

In this blog, we’ll explore how tax loss harvesting works, its benefits and drawbacks, and step-by-step instructions on how to use it effectively.

Understanding Tax Loss Harvesting

Tax loss harvesting involves selling investments that have decreased in value, thereby realising a capital loss. These losses can be used to offset capital gains from other investments, reducing your overall tax liability. If your losses exceed your gains, you may be able to offset up to $3,000 of ordinary income per year, with the excess carried forward to future tax years.

Key Terms:

Capital Gain: Profit from selling an investment for more than its purchase price.
Capital Loss: Loss from selling an investment for less than its purchase price.
Carryforward Losses: If capital losses exceed capital gains in a given year, they can be carried forward to offset gains in future years.

Benefits of Tax Loss Harvesting

Tax loss harvesting offers several advantages, including:

Reducing Taxable Income: By offsetting gains with losses, you reduce your capital gains tax, allowing you to keep more of your profits.
Deferring Taxes: Using tax loss harvesting to offset gains allows you to defer taxes, enabling your capital to grow without the drag of taxation.
Improving After-Tax Returns: Lowering taxes on investment gains effectively increases your after-tax return, which can compound over time and increase portfolio performance.
Portfolio Rebalancing Opportunity: Tax loss harvesting offers a chance to rebalance your portfolio, replace underperforming assets, and improve alignment with your investment goals.

Limitations and Drawbacks of Tax Loss Harvesting

While tax loss harvesting can be beneficial, it also has potential downsides:

Wash-Sale Rule: This rule prevents investors from repurchasing the same security (or one “substantially identical”) within 30 days of selling it for a loss. If you do, the loss may be disallowed.
Market Timing: Selling investments purely for tax purposes can lead to market timing issues. You may miss out on future gains if the sold investment rebounds.
Transaction Costs: Buying and selling investments may incur transaction fees, though many platforms now offer commission-free trading.

Step-by-Step Guide to Tax Loss Harvesting

Here’s how to apply tax loss harvesting effectively within your portfolio:

Step 1: Review Your Portfolio for Potential Losses

Begin by identifying underperforming assets in your portfolio. Look for investments that have declined in value compared to their original purchase price and are no longer aligned with your investment strategy or risk tolerance.

Tip: Regularly review your portfolio, particularly during market downturns or before the end of the financial year when tax planning becomes a priority.

Step 2: Identify Offset Opportunities

Calculate your capital gains for the year, as you can only offset losses against gains. If you’ve realised any gains, selling a loss-making asset can reduce or eliminate the tax on those gains.

Prioritise Short-Term Gains: If you have short-term capital gains (from assets held for one year or less), they’re typically taxed at a higher rate. Consider using losses to offset these gains first.

Step 3: Choose Replacement Investments to Maintain Portfolio Balance

To avoid disrupting your portfolio’s balance and growth potential, consider reinvesting in a similar asset to replace the one you sold. Ensure the replacement investment is not “substantially identical” to avoid violating the wash-sale rule.

Example: If you sell shares in an Australian technology ETF at a loss, consider reinvesting in a global technology ETF or an Australian broad-market ETF to maintain market exposure without violating the wash-sale rule.

Step 4: Execute the Trade and Record the Loss

Once you’ve identified the securities to sell and the replacement investments, execute the trade. Record the transaction details, including the date, sale price, and the amount of the loss.

Tip: Keep detailed records of all transactions for tax reporting, including purchase and sale dates, as well as the amount of capital gain or loss realised.

Step 5: Use Losses to Offset Gains on Your Tax Return

When filing your taxes, report the capital losses and apply them against any gains. If your losses exceed your gains, use the remaining losses to offset ordinary income up to the limit, and carry forward any excess to future years.

Carryforward Losses: Any unused losses are valuable because they can offset gains in future years, potentially saving on future tax liabilities.

Understanding the Wash-Sale Rule and How to Avoid It

The wash-sale rule prevents investors from claiming a tax loss on an investment if they repurchase the same security (or a substantially identical one) within 30 days of the sale. To avoid violating this rule:

Wait 30 Days: If you plan to repurchase the same security, wait at least 30 days after selling.
Buy a Different Security: Instead of waiting, consider buying a different security that provides similar market exposure but is not substantially identical.

Example of Wash-Sale Compliance: If you sell shares in Company A for a loss, avoid buying Company A again within 30 days. Instead, you could buy shares in Company B within the same sector to maintain similar exposure without violating the rule.

When to Consider Tax Loss Harvesting

While tax loss harvesting can be used year-round, specific times may be more advantageous:

During Market Downturns: Broad market declines can present opportunities to harvest losses across multiple investments, especially in growth sectors.
End of Financial Year: Tax loss harvesting before the end of the financial year can lower your taxable income and reduce your tax bill for that year.
When Rebalancing Your Portfolio: If you’re rebalancing, tax loss harvesting allows you to align your portfolio with target allocations while optimising your tax situation.

Integrating Tax Loss Harvesting with Overall Investment Strategy

Tax loss harvesting should support, not override, your broader investment goals. While reducing taxes is valuable, it’s essential to avoid excessive buying and selling, which can lead to unnecessary costs or portfolio misalignment.

Best Practices:

Keep Your Long-Term Goals in Mind: Only harvest losses that don’t detract from your long-term goals.
Minimise Transaction Costs: Use a brokerage with low or no trading fees to prevent transaction costs from eroding the tax benefits.
Avoid Over-Harvesting: Excessive loss harvesting can erode your asset base. Limit harvesting to securities that are genuinely underperforming or no longer align with your strategy.

Consider Working with a Tax Professional or Financial Adviser

While tax loss harvesting can be an effective strategy, it can be complex to manage, especially when accounting for wash-sale rules and ensuring your portfolio remains balanced. Consulting with a financial adviser or tax professional can help you:

Identify Optimal Losses to Harvest: Professionals can help you find the best opportunities to harvest losses without compromising your portfolio’s integrity.
Comply with Tax Laws: Experts can guide you on the wash-sale rule, carryforward loss rules, and other regulations.
Maximise Tax Efficiency: An adviser can integrate tax loss harvesting with other strategies, like rebalancing and tax-efficient asset location, to optimise your portfolio.

Conclusion

Tax loss harvesting is a valuable strategy for managing capital gains and reducing your overall tax liability. By selling underperforming assets and offsetting gains with losses, you can lower your taxable income and improve your portfolio’s tax efficiency over time. For best results, be mindful of the wash-sale rule, consider the costs of transactions, and align tax loss harvesting with your long-term investment goals. Working with a financial adviser or tax professional can further ensure that your approach is compliant, tax-efficient, and tailored to your unique financial situation.