Unfortunately, you actually can’t turn coal into a diamond. However, both share such closely related chemical make-ups that such statements almost seem accurate. From a certain point of view, there is at least some metaphorical truth to this statement as coal’s value is in the eye of the beholder. On a frigid winter night, a bag of coal may be worth its weight in diamonds.
With the holidays around the corner, an all too familiar image of the plump almost cherubic bearded man is conjured. For the good boys and girls, he seeks to bring joy around the world leaving sweets and treats in the stockings with care. For those who were naughty, he leaves a lump of coal. Among investors, benevolent or not, each year they too might find coal, but not in their stockings, but within their portfolio.
As you wrap up the end of the year, if you are among those discovering those metaphorical lumps of coal sitting in your portfolio, remember that there is an opportunity in a loss. For the enterprising mind, these seemingly bad investment picks can be a powerful tool come tax time!
Mining for Coal or Harvesting Losses?
When it comes to taking advantage of losses in your portfolio, it is important to understand Tax-Loss Harvesting. In short, tax-loss harvesting is the process of selling off securities (such as stocks, bonds, mutual funds, ETFs) to offset a capital gain from another sale.
This strategy can be implemented at any time during the year, but most commonly is utilized near the end of the calendar year as individuals begin to get a better sense of their potential tax liabilities. In this strategy selling a security with a loss creates a “credit” to which one can offset realized gains within a portfolio.
For example, if an investor purchased Security ABC for $1,000, and sold it for $500, there exists a $500 capital loss. If in the same year Security XYZ was purchased for $1,000 and sold for $1,700, the investor could take their gain ($700), and match it with their loss (-$500), for a total taxable gain of $200.
Now let’s say in another scenario that the same investor bought Security ABC for $10,000 and sold it for $5,000. In the same year, this investor bought Security XYZ for $3,000 and sold it for $5,000. In this scenario, the investor has a $5,000 capital loss, and a $2,000 gain. What do they do with the other $3,000 loss? Does it disappear? Are they out of luck?
Well, fortunately, the current tax law permits individuals and those married filing jointly to deduct up to $3,000 of capital gain losses each year against other income such as wages or salaries. If an investor ever has a year of catastrophic losses that cannot pair with other capital gains, and where even the $3,000 deduction leaves remaining losses, there is also the ability to carry any remaining losses over to future years. Thus one year’s losses are another year’s tax-breaks!
It is worth noting that this strategy must be implemented in an account that does not already provide a tax-shelter such as an individual brokerage account and normally you cannot declare a loss inside of a 401(k) or IRA except with rare exceptions.
Though selling a security with a loss to offset another security with a capital gain can be a great strategy, it is not without some perils. Particularly with changes to cost basis reporting rules that the IRS has put into effect, it has never been more important to be wary of what you buy, sell, and purchase yet again.
While the IRS permits you to recognize a loss, it does not want to encourage investors to jump in and out of an investment just to recognize a loss. To prevent this the IRS has regulated Wash-Sale rules. Essentially a wash sale occurs when an individual sells a security for a loss and, within 30 days before or after the sale, buys a “substantially identical” security (including options contracts). For married couples or individuals with a controlling interest in a company (their activity can also count towards a potential wash sale).
Perhaps an easier way to think of the wash sale window is picturing a 61-day window, consisting of 30 days prior to a sale and then 30 days after the sale. For example, if an investor bought shares of ABC Company on September 1st for $5,000, and on September 30th sold the position for $4,000, they would ordinarily have a $1,000 loss. However, if they then purchased shares of ABC Company on October 30th, the initial loss could not be utilized as a tax loss since shares of the “same” company were repurchased within 30-days of the original sale.
Investors should be cautious in frequent trading which can lead to potential excess trading fees as well as potential wash sale transactions. That said, if you do end up with a wash sale, all is not lost, the IRS will permit disallowed losses to be added to the cost of the newly purchased holding, and thus it increases the cost basis lowering the future tax liabilities.
In our scenario above let’s say the repurchase of shares was at a cost of $3,000, the investor could then add back the $1,000 disallowed loss creating a new cost basis of $4,000. If they then sold these shares for $5,000, they would have a $1,000 capital gain as opposed to a $2,000 gain. So while that disallowed loss did not go away, in essence, it was delayed.
This holiday season it is important to remember that there is much to be thankful for regardless of what we find in our stockings. When it comes to portfolio management having the right team of experts in your corner can help unearth potential diamonds in your own portfolio. Whether you are in need of an end of year financial review or are looking to make 2020 a year of new financial beginnings, My Financial Coach is here to help you uncover your financial potential by partnering with you and our many Subject Matter Experts!
Andrew J. Crosby, CFP®, ChFC®, RICP®
Lead Financial Coach