Profiting from investments and reducing tax liability may seem like competing goals, but both can be accomplished with a little proactive tax planning. In the world of tax strategy, timing is key to keeping taxes low. One sometimes-overlooked approach is to be deliberate about when you realize and deduct financial losses. This type of nuanced tax advice may take time to outline for your clients, but the result can be major savings that demonstrate the value of working with a tax professional.
In this blog, we’ll cover two strategies that can turn a downfall into a win: loss harvesting and loss carryovers.
The goal of loss harvesting is to offset capital gains with unrealized losses. If a taxpayer owns an asset that now has a lower fair market value than when they purchased it, it may not be on their radar to do anything with that asset. By selling that asset at a loss at a time when they need a tax deduction, the taxpayer can turn that loss into a win.
However, keep in mind that a taxpayer cannot sell an asset at a loss, claim a tax deduction for that loss, and then immediately turn around and repurchase that asset. The IRS has rules in place to prevent taxpayers from falsifying a loss just to get the tax break. That limitation is also known as the “wash-sale rule.” Specifically, the IRS prohibits taxpayers from selling an investment for a loss and replacing it with a “substantially identical” investment within 30 days of the sale—either before or after the date of sale.
First, determine if the taxpayer intends to replace that asset in some way. If so, there are some ways to get around that wash-sale limitation. If the taxpayer sells an investment in a security, they may be able to buy securities of a different company in the same type of industry or shares of a mutual fund in that same type of industry. Similar investments do not meet the “substantially identical” test.
Alternatively, the taxpayer can simply wait for 31 days before buying a new investment. According to the “before or after” rule, they can also preemptively make that purchase at least 31 days in advance. So let’s say a taxpayer has stock they have been meaning to sell for a while. Rather than waiting to buy the “replacement” stock, you could recommend they make the purchase now, say on May 1st, and then wait the allowed 31 days before selling the unwanted stock, say on June 1st. The mistake many people make is waiting until they have already received the capital gain to try to actualize a loss to mitigate the tax impact.
Though we won’t get into a discussion on cryptocurrency here, take note that at this time the wash-sale rules do not apply to crypto transactions. So it is possible to have a wash sale with cryptocurrency, lock in that capital loss, and immediately repurchase the same cryptocurrency. Of course, legislation may change to address this, so you will want to keep an eye out for recent updates—but right now, this can work as another strategy for loss harvesting!
Loss carryovers allow taxpayers to carry a tax loss over to a future year to offset a profit rather than recognizing the loss in the year it occurs. If a taxpayer has more losses than gains, they are allowed to deduct up to $3,000 per year (or $1,500 for married filing separately). Even better, they can continue to do so over multiple years until the full amount of that capital loss has been deducted. This rule can be used to offset various types of income, including wages, self-employment, and business income. Loss carryovers can continue until the taxpayer’s death but cannot be passed on to an heir.
Loss carryovers are a great example of the impact of proactive planning on your total tax liability. To take an example, let’s say a client owns a rental property. One year, the client has sizable capital loss carryovers from stock market or cryptocurrency losses. If that rental property has an unrecognized and unrealized gain, it might be advantageous to sell that property, since the owner now has losses to offset the gain. The taxpayer might even consider buying a new piece of property, giving them a higher depreciable basis. Then their ongoing income from that rental activity can pay a lot less in tax on that income.
Especially with younger taxpayers, check on the possibility of unrealized capital gains that could turn into a tax deduction. Determine if the taxpayer has purchased assets, say some stock investments, that they have stopped actively paying attention to, assuming that it will do well and generate income. The question now is whether that asset is making money on its own, or if it’s not doing well, it could be put to better use as a loss harvest or loss carryover.
The counterintuitive wisdom of the tax world is that a loss can become a gain—with a little advance planning. By investigating the possibility of loss harvesting and loss carryovers, you can add significant value for your clients, bringing to light tax strategies that they are unlikely to employ on their own. To increase your knowledge of the best tax strategies for investments, become a Certified Tax Planner today.