Many articles and websites tout the wonderful benefits of tax-loss harvesting, especially if you ask the robo-advisers. Should we take these claims at face value or is there more to the story? A closer look reveals that tax-loss harvesting is really not that beneficial. In fact, it's really only beneficial if you have unavoidable gains. But if you have avoidable gains, then it generally won't make any sense to use tax-loss harvesting.
Let me provide you with the assumptions on which this conclusion is based. First, all gains and losses are considered long-term in nature. Second, harvested loss assets are repurchased at the value they are sold. Third, our definition of tax-loss harvesting assumes that there is an equal gain to offset the loss. Finally, assets that generate a realized gain get reinvested and a higher cost basis is established.
Not all tax-loss harvesting transactions are created equal. I've read many articles about tax-loss harvesting, but none of them distinguishes between unavoidable gains and avoidable gains. This is a very important distinction.
Let's first take a look at unavoidable gains. Unavoidable gains are realized gains that you have no control over. A good example of this would be mutual fund capital gains distributions. Assume that you have a mutual fund that issues a $20,000 long-term capital gains distribution. If you do not tax-loss harvest, then you will likely incur taxes on your gains. At a 15% long-term capital gains rate, you will pay $3,000 in taxes. To satisfy the taxes, we'll assume the $3,000 comes out of your portfolio. If you do TLH, then the $3,000 stays invested in the portfolio. The tax will eventually be owed when you ultimately sell the security, but for now it is deferred. The growth on the tax deferral is where the benefit lies if you TLH unavoidable gains.
Now let's take a look at avoidable gains. Avoidable gains are gains that you choose to incur by selling an appreciated asset. Should you deliberately sell an asset with a gain just to offset a loss, even if it's a very large loss?
The answer is that it doesn't matter whether you TLH or not in this situation, as the results are identical. Let's use an example. Assume you buy ABC asset at $100 and XYZ at $80. Total cost basis is $180. ABC falls to $50. If you sell, it will incur a loss of $50. Let's also assume that XYZ has appreciated to $130, which is a gain of $50. You would have to voluntarily sell XYZ to generate a gain to cover the loss. Assuming you navigate the wash sale rules and buy both securities back at the same price you sold them, then you would buy back ABC at $50 and $XYZ at $130 for a new cost basis of $180 – the exact same as the beginning. Therefore, this two-asset portfolio will face the same future gains regardless of whether you TLH or not. In other words, there is no tax benefit to TLH when you have avoidable gains.
JUST THE LOSSES
In fact, I'll take it a step further. When you have avoidable gains, you generally will be better off harvesting losses, but not the gains, even if this means having to carry forward losses for years to come. Many would have you believe that a 50% loss situation like this would present an ideal (if not perfect) time to TLH, but the math proves otherwise.
Tax-loss harvesting can be beneficial when you have unavoidable capital gains. But when it comes to avoidable capital gains, there is no tax benefit. In those situations, it is usually preferable to just harvest the losses, not the gains.
Brad Tinnon is the owner of B.E.S.T. Wealth Management.