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Making Lemonade

Greg Spears

YOU KNOW IT’S BEEN a rotten year for investors when it’s time to brush up on the rules for tax-loss harvesting. It’s one way to turn negative returns to your advantage, provided you act before year-end.

If you have taxable investments that have lost value this year—and who doesn’t? —the basic idea is to sell them in 2022 to lower the taxes you owe. Realized losses can be used to offset any investment gains you’ve realized this year. Excess losses can also offset up to $3,000 of regular taxable income each year, including dividends and interest payments.

If you don’t use up all your losses this year, they can be carried forward. My tax prep software somehow remembers my previous years’ heartaches and subtracts them from future years’ gains until the account is zeroed out. Tax-loss harvesting can be applied to stocks, bonds, mutual funds—and even cryptocurrencies, which are big this year, only in the wrong way.

If you’re selling a holding that you want to own again, know the wash-sale rule. The IRS will disallow a tax loss if you buy the same or a substantially identical investment within 30 days before or 30 days after you sold at a loss. The idea is not to allow a taxpayer to deduct a loss on an investment that he effectively hung on to.

Selling Johnson & Johnson at a loss and then buying Merck shares within 30 days won’t run afoul of the wash-sale rule because they’re similar but not substantially identical, according to the IRS. Selling AT&T 4% bonds due in 2028 and then buying AT&T 4.25% bonds due in 2027, however, would raise a red flag as the two investments are practically the same.

Mutual fund investors can also get tripped up if they have their dividend payments automatically reinvested. For example, if an investor sells part of her fund holdings at a loss on Dec. 10 and the fund then pays her a dividend that’s reinvested in new shares on Dec. 20, this is a wash sale for tax purposes and part of the tax loss would be disallowed.

Another unintended consequence can occur if you swap into a new mutual fund that then pays a taxable year-end distribution. This doesn’t violate the wash-sale rule, but it does mean you’ll have a bigger tax bill than you expected. Funds publish estimates of their year-end distributions in November, so you can avoid this outcome with a bit of sleuthing. Even a fund that’s down for the year can make a taxable distribution.

Harvesting tax losses won’t make an investment in Meta Platforms (symbol: META) or Peloton Interactive (PTON) any less painful. After a wreck of a year like 2022, however, it does offer the chance to reduce the taxes you owe, and perhaps for years to come. It’s not exactly a margarita on the beach, but it is lemonade from lemons.

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Cody Mercurio
Cody Mercurio
10 days ago

Nate Allen: The $3000 cap gain loss adjusted for inflation each year since 1976 would today be $16,078.79 using the Bureau of Labor’s CPI calculator.

William Perry
William Perry
11 days ago

A good and timely article. For an older companion article I also like the piece authored by Michael Kitces. https://www.kitces.com/blog/the-wash-sale-problem-when-tax-loss-harvesting-almost-substantially-identical-mutual-funds-and-etfs/

When considering taking a wash sale loss there is also guidance in IRS Revenue Rule 2008-5 which advises that purchases of the same investment within your IRA in the applicable 61 day period of the loss sale will also cause the wash sale rule to be applied. Kitces also had an article on this – https://www.kitces.com/blog/irs-shuts-down-wash-sale-evasion-technique/

My experience for the last decade has been that brokers do a good job on tax reporting wash sale transactions within the same taxable broker account. Broker’s tax reporting outside of the same taxable account appears to be nonexistent and the burden falls on the individual taxpayer to comply. Just more individual tax complexity we would all like to avoid.

Best, Bill

B Carr
B Carr
11 days ago

A good article and so well written in a conversational style, as usual. Thank you.

Cody Mercurio
Cody Mercurio
11 days ago

I cannot understand why the deductible tax loss is only limited to $3000 per year? Each time Congress considers tinkering with the tax laws I check out the proposed law to see if there is anything in the bill that increases the $3000 per year loss. Nothing!
Perhaps a national investors petition and push is needed to motivate Congress to increase this deduction.

Nate Allen
Nate Allen
11 days ago
Reply to  Cody Mercurio

Agreed! Larger and pegged to inflation.

Actually everything (tax free $250K house sail gain, IRA/401(K) contributions, etc.) It would make too much sense (and Congress’ life easier!) if they just pegged everything to inflation.

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