Every so often, the stock market goes through periods of volatility.
When Coronavirus first appeared, it hit the market very hard. Within days, the market had entered into a correction and then into a bear market. But almost just as quickly, it recovered some of its losses despite massive rates of unemployment not seen since the Great Depression.
While we never enjoy stock market losses, they can represent an opportunity to reduce your tax burden.
Whether you already invested in the stock market or are new to investing due to the market downturn, there are ways you can use any losses you sustain to lower your taxes when you file, and even in subsequent years.
Whenever you have a capital loss, where your assets like stocks and bonds lose value, you can use them to offset capital gains. Tax-loss harvesting is the term used by investors to mean the realizing of capital losses so you can use them to offset other gains.
Here’s an example.
Let’s say you have Stock Fund A that will generate a $10,000 gain if you sell it now. And you want to sell it because the stock has had a good run, and you’re uncertain where the market is heading from here.
But because of the large amount of the gain, you’re hesitant to sell because it would increase your taxes owed for 2020. While we never want to make investment decisions entirely based on taxes, taxes do play an important role.
Let’s say you also have Stock Fund B, which is worth $7,000 less than when you bought it. You don’t really want to sell the shares in the fund because you believe the decline is temporary, and the sector’s long-term prospects are still excellent.
But if you sell both funds, you’ll be able to partially offset the $10,000 gain in Stock Fund A with the $7,000 loss from the sale of Stock Fund B. That will reduce your net gain to $3,000, producing a much more manageable taxable capital gain. You’re “harvesting” the loss from the fund to offset the gains in another fund. This strategy will not only lower your taxable capital gain, but is also a tax strategy used if you want to sell winning stock and your income is already putting you in a higher income tax bracket.
Tax-loss harvesting is a form of income tax deferral that you can use with non-tax-sheltered investments. By selling losing asset positions, you’ll minimize the capital gains taxes on your winning sales.
From a tax standpoint, it’s an excellent strategy. But from an investing standpoint, you may not feel great about it because you’re still left with the dilemma that Stock Fund B has excellent future prospects, and you really don’t like the idea of selling your position.
No problem. You can buy back your position in Stock Fund B after the sale… as long as you follow the rules for wash sales explained below.
Watch Out for the IRS “Wash-Sale” Rule
If tax-loss harvesting sounds too good to be true, there is a catch – the wash-sale rule.
You can’t immediately buy back into Stock Fund B when you want to use the loss to offset gains. You have to wait, or buy shares in a fund which is substantially different.
Specifically, a wash-sale is considered to have occurred anytime you sell or trade securities at a loss, and then do one of the following within 30 days before or after the sale:
- Buy substantially identical securities.
- Acquire substantially identical securities in a fully taxable trade.
- Acquire a contract or option to buy substantially identical securities.
If you do, the IRS can disallow the loss on the assets sold. But there are a couple of steps you can take to make sure your capital loss can offset your gain.
The first is to simply wait until at least 31 days pass before reinvesting in Stock Fund B. The other is to invest instead in a similar fund. If Stock Fund B is a technology fund, you can make an equal investment in a competing technology fund.
Use this strategy, and wash sale rules won’t apply, giving you the full benefit of tax-loss harvesting.
Using Capital Losses to Offset Other Income
Let’s say your entire stock portfolio is down due to the recent stock market decline. You want to keep most of your investments, but Stock Fund C is way down, and it looks like it may not be coming back anytime soon.
Even if you don’t have any taxable capital gains that need to be offset, the IRS still allows you to apply up to $3,000 in capital losses to other income sources, including job income.
If the sale of Stock Fund C will generate a $12,000 loss, you’ll be able to offset up to $3,000 of it to reduce your other income.
But what about the remaining $9,000 in losses that you can’t deduct in 2020?
The IRS will allow you to carry the remaining loss forward into future years until they are used up.
If you have $15,000 in capital gains in 2021, you can apply the entire $9,000 loss carryover from 2020, which will reduce your taxable gains to $6,000 for 2021.
If you don’t have any capital gains in 2021 you can claim $3,000 of the carryforward against other income.
While we can’t know how Coronavirus will affect the stock market for the rest of 2020, these are some of the steps you can take to reduce your taxes when you file, whether you still have to file your 2019 taxes this year or for the taxes you file next year.
Your portfolio may not come close to fully restoring to the heights reached in February, but at least you may get a tax break.
Don’t worry about knowing the tax implications of investing, when you file. TurboTax Premier will ask you simple questions about you and your investments and give you the tax deductions and credits you’re eligible for based on your answers. TurboTax Premier can help you accurately figure out your gains and losses and is the only major online tax preparer that supports importing over 1500 stock and 2,250 cryptocurrency transactions at once, directly from financial institutions, saving you time and ensuring accuracy. TurboTax Premier has partnered with over 300 financial institutions and investment platforms to allow you to auto-import your investment info seamlessly when doing your taxes.
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