With the fourth quarter in full swing, not only are the holidays approaching, tax season is coming up as well. This is the time of year when many financial advisors talk taxes with their clients, especially if those clients have capital gains and if there is the potential for tax loss harvesting. Tax loss harvesting is the act of selling a losing position to offset capital gains created by income or the sale of profitable investments.

Tax Loss Harvesting

So, how exactly is this achieved without altering the long-term investment goals of the client? The security sold to create the tax loss opportunity is simultaneously replaced by a similar investment to maintain proper asset allocation within the client’s portfolio. For example, an advisor can sell a market cap-weighted European exchange-traded fund (ETF) for a client at a loss and replace that ETF with a dividend-weighted or currency-hedged fund that’s focused on European equities.

When identifying tax loss harvesting opportunities, advisors must be aware of the Internal Revenue Service’s (IRS) wash-sale rule. The IRS rule states that when you sell a security at a loss, you cannot purchase one that is substantially identical to replace it within 30 days before the sale and 30 days after the sale is complete. If an advisor has done so and attempts to include the loss on the client’s tax filing, the IRS will disallow the tax benefit. The IRS does not offer an explicit definition of what a “substantially identical security” is, so this rule is vague. ETFs offer an advantage when it comes to tax loss harvesting because the IRS also does not consider them “substantially identical” to mutual funds. Furthermore, it is fairly easy to examine if the ETF you are selling and the ETF you are considering buying track the same index. This will give you an indication if the securities may be too similar.

Strategies for Tax Loss Harvesting