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Drink Your Financial Lemonade in November

When life gives you lemons, make lemonade – so the saying goes. Hence, when the market gives you losses, avoid paying taxes. Taxes come in many shiny packages (income, sales, capital gains, property, estate, etc.), and while some are hard to avoid, others can be easily be minimized. Many of us have made tax deductible donations throughout the year that help our favorite charities and lower our taxable income, but only a few harvest losses. Tax loss harvesting is the act of intentionally selling an investment at a loss to offset current and/or future capital gains. If executed properly, it is a powerful technique used to significantly lower one’s taxable income and hence taxes.

Of course everyone prefers to see their stock portfolios rise in value, even if that means having to pay tax on capital gains. But as we have painfully witnessed in recent years, portfolios can also incur losses. While no one likes to see their investments go down in value, savvy investors can capitalize on such losses and do as the old saying goes, “when life gives you lemons, make lemonade.” Current IRS rules limit capital loss deductions to only $3,000; the good news is that losses greater than $3,000 can be carried over and used in future years. For example, assume you purchased an investment for $20,000 and sold it for $10,000, you can only deduct $3,000 each year from your taxable income. The remaining $7,000 would carry over to future years to offset future capital gains. So if the following year you sold another investment for a $15,000 capital gain, you would pay tax on only $8,000 ($15,000 – $7,000). Tax loss harvesting is when you intentionally sell an asset (even if you still like the asset) to recognize and bank (harvest) the loss for future use. Here is how it works.

Assume you bought investments in 2007 worth $100,000, but they are now worth $60,000. You initially purchased the investments for long term growth and have no intention of selling them because the investment still helps meet your long term goals. While you have a 40 percent loss, the loss is unrecognized because you have not sold anything. By harvesting your losses, you would sell your investments now, realize a $40,000 loss which you can save to offset future capital gains, and repurchase your investments. Your investments would still be worth $60,000, but now you have “lemonade” you can drink for years to come. You are still only limited to $3,000 per year in losses as discussed above, but now you have $40,000 in losses you can save and use to off-set any future capital gains for multiple years that only expire upon death. So let’s assume you had no other sales for the next few years and then after 5 years, you sell a rental property for a $50,000 gain, you can use the $40,000 loss to off-set that gain and only pay tax on $10,000. This will substantially decrease your taxes.

As with everything, the IRS has rules and limitation. The IRS wash-sale rule stipulates that if you sell an investment to recognize a loss, you cannot buy another “substantially identical security” within 30 days. So for instance, if you sold State Street S&P 500 SPDRs (ticker: SPY), you cannot replace it with the iShares S&P 500 Index (ticker: IVV) because they both own essentially the same investments. However, you can purchase a temporary investment that is not essentially same, but is highly correlated. Using the same example, you could sell the SPY to recognize a loss and purchase the iShares Russell 1000 Value Index (ticker: IWD) as its replacement. The two assets are not essentially the same, but they are both highly correlated and tend to move in tandem.

No one likes to lose money on their investments, but when the markets are as volatile as they have been these last few years, give yourself the gift that keeps on giving for years to come – harvest your losses. If done properly, you could avoid paying taxes on capital gains for years. Please be aware that tax loss harvesting is only relevant in your taxable accounts, and not in your IRAs, 401ks, or other tax efficient investment vehicles. Each person’s tax situation is different so investors should consult with their financial and tax advisors.

Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” financial advisory and investment management firm located in Los Angeles, CA. Contact Ara at aoghoorian@acapam.com or on the web at www.acapam.com for a complimentary consultation.