Now that the Labor Day weekend is behind us my thoughts turn to autumn. The fall is my favorite time of the year. I love the activities of the season... football, duck hunting, and cool morning runs. Farmers and financial planners prepare for the upcoming harvest.
What do financial planners harvest? Taxes, of course.
Here is what I mean. Suppose you have two investments in a fully taxable account, call them A and B, both purchased earlier this year. To buy A you invested $100 and to buy B you invested $2000. Now A is worth $1100 (up $1000) and B is worth $1000 (down $1000). Since the value can still fluctuate, we call these paper gains and paper losses. The tax code tells us they are unrecognized and we owe no taxes yet.
Now you want to sell A. When you do your paper gain becomes a recognized gain. On your tax return for 2007 you will pay income tax on the $1000 you made.
Did you know there is a way to defer that income tax? The solution lies with investment B. You can offset the $1000 gain from investment A if you sell investment B and recognize the $1000 loss. Since the gain and loss negate each other, you end up paying no tax this year.
But you also ended up right back where you started. IRS wash rules prohibit you from purchasing B again within 30 days. If you do, then the IRS will argue that the loss was never really recognized. However, you can take the money from the sale of B, park it someplace for 31 days, and then repurchase B.
Keep in mind you are not avoiding the taxes, you are merely postponing them. When you repurchase B (assume the price never changes in the 31 day waiting period) you are re-purchasing the same number of shares at a lower cost than you originally did. That means if you eventually sell B for a profit you have transferred the taxes which would have been paid on A to B. Perhaps by then you will own an investment C and you could theoretically continue to defer the taxes even longer!
There are risks involved such as price changes to B during those 31 days. It is good news if the price of B falls since you would be able to re-purchase more shares than you sold for the same money. On the other hand, if the price of B rises you would either have to purchase fewer shares or invest more money to maintain your position. Also keep in mind that more transactions generally mean more transaction expenses.
Other perspectives:
- Tax Loss Harvesting & Wash Sale Rule @ QVM Group
- Tax Loss Harvesting in the Mutual Fund and ETF Context @ Investing for Financial Success
Comments