Everyone likes growing wealth, except when it is time to file tax returns. Because capital gains represent taxable income, they can make a large difference in your final tax bill for the year, which can be problematic if you do not plan accordingly. Tax loss harvesting is one way to plan for capital gains and enjoy more of your new wealth.
What are capital gains and losses?
Capital assets are items of property, whether physical or intangible, such as real estate, mutual fund or stock shares, a vehicle, rare stamps, cryptocurrency, or tickets to a Taylor Swift concert. When you sell a capital asset at a profit, you have a capital gain. These gains are taxable unless excluded by law. Examples of exclusions are:
Items held for resale in the normal course of business are inventory, not capital assets.
Capital gains on the sale of a principal residence are nontaxable under certain circumstances.
On the other hand, if you sell a capital asset at a loss, you have a capital loss. Capital losses on personal-use property, such as a television set or your personal vehicle, are not deductible. These items serve a function and are expected to experience devaluing wear and tear over time. On the other hand, if you have a capital loss on property such as stocks or mutual funds (which are generally expected to rise in value over time), the capital loss is deductible.
How do I know whether I have a profit or loss?
At its most basic level, comparing the sales price and purchase price tells you whether you have a profit or loss. If you sell an item for an amount greater than the amount you paid to purchase it, you have a profit. If you sell an item for less than its purchase price, you have a loss.
There are additional nuances to consider. Your basis in an item is its total acquisition cost, which may include more than just the purchase price. Besides the purchase price, you might have sales tax, installation, or other costs. When you purchase real estate, for instance, there are myriad additional fees beyond just the purchase price. (Be careful, though: not all of these become part of the basis.) If you receive property by inheritance or gift, determining its basis is more complicated, so you should do that soon after receiving the item while the information is still available. Additionally, you may need to adjust the basis to account for improvements or depreciation during your period of ownership. IRS Publication 551 discusses how to calculate the basis in detail.
When you sell an item, any expenses of the sale—commissions, delivery, transaction fees, etc.—also get added to its basis for purposes of computing capital gains.
As an example, assume you purchase a widget for $200. You also pay $12 in sales tax and a $5 delivery fee. Later, you sell it for $225. You pay an Etsy fee of $7 to process the transaction and $15 for priority shipping to the buyer. What is your capital gain or loss? There is more to it than just $225 sales price minus $200 purchase price equals $25 capital gain.
Basis = $200 purchase price + $12 sales tax + 5 delivery fee = $217
Sales price = $225
Expenses of sale = $7 transaction fee + $15 shipping = $22
Net = $225 sales price – $217 basis – $22 expense of sale = –$14 (i.e., a $14 loss)
How do I report capital gains and losses?
You report capital gains and losses on Form 8949 when you file your tax return for the year. Short-term transactions and long-term transactions are grouped separately. The sum of all your short-term transactions is your total short-term capital gain (or loss) for the year, and the sum of all your long-term transactions is your total long-term capital gain (or loss) for the year. These sums flow through to Schedule D, where you combine them with other amounts (like capital gain distributions within mutual funds) to figure your total capital gain or loss for the year.
Your total capital gain or loss for the year gets added to or subtracted from your other types of income on Form 1040 to determine your tax liability for the year.
Do I really need to report this?
Yes, you must actually report your capital gains. Not reporting income is the quickest way to trigger an audit.
You should also report all deductible capital losses to offset your capital gains. This can help you enjoy more of the wealth you built. For instance, if you sell ABC stock at a $500 gain, and then sell DEF stock at a $600 loss, your total capital gain is a $100 loss, which lowers your overall taxable income. Finding losses can help you win at taxes!
Be sure the losses are actually deductible. If you sell your personal-use car for less than you purchased it for, that represents a nondeductible personal capital loss. Unfortunately, the flip side is not also true: a gain when selling your personal-use car is taxable.
Brokerages report sales of stock and mutual fund shares to the IRS, similar to employers reporting wages. If the basis is not reported to the IRS—either by you or the brokerage—the IRS will assume the basis is $0! This means the IRS could think you made a profit on a stock that you sold at a loss.
I have seen many folks not report deductible losses. They are surprised to receive an audit notice from the IRS due to unreported income. While we can prevail in these audits, the best course of action is to avoid them in the first place.
What is tax-loss harvesting?
Tax-loss harvesting is the process of picking losers to offset your winners. When you own a particular security (i.e., shares of stock or a mutual fund) and are considering selling it, you can calculate your basis by one of the following methods:
First in, first out (FIFO): Sell shares in the order received.
Last in, first out (LIFO): Sell the most recent shares acquired.
Average cost: Divide the total cost for all shares by the number of shares held to determine the average cost per share.
Specific lot identification: Determine the specific shares sold each time you sell.
Deciding which shares to sell can impact whether you are selling the security at a loss or a gain, particularly if you invested in the security over a long period of time. For example, if you purchased shares of VTSAX on December 31, 2020, for $94.74 and sold them when VTSAX was worth $90.00 per share, you would experience a capital loss. If you bought VTSAX on October 14, 2022, for $87.27 per share and sold them when VTSAX was worth $90.00 per share, you would experience a capital gain. Indicating which shares you sell is important to have the outcome (whether a loss or a gain) you are seeking.
To use this knowledge, simply tell your brokerage which method to use to calculate your basis. A few quick notes:
A “lot” is a group of shares purchased in one transaction; every share in that transaction will have the same price. If you bought 10 shares for $145 each on October 10, 2018, your 10/10/2018 lot equals 10 shares for $1450 total. Lots will typically vary in size, amount, and frequency. You can sell a lot in whole or in part.
Strictly speaking, FIFO and LIFO are subsets of specific lot identification.
You can use different methods for different holdings. In the example above, you could use the average-cost method for ABC stock and the LIFO method for DEF stock.
Once you use the average-cost method for determining basis, you typically are stuck with that method while you continue to own any shares of that particular holding (unless you sell them all, and restart again later, because then it is a new holding).
Specific lot identification is where you can use tax-loss harvesting.
Assume, for instance, that you have been accumulating shares of VTSAX for several years, and you sell $50,000 worth for a down payment on a house. Assume further that you can still choose which basis method to use since you have never sold any shares of this holding before.
Under the average-cost method, your basis on that $50,000 of VTSAX might be only $30,000. That would result in a $20,000 capital gain. Do you want to pay taxes on a $20,000 gain?
Under the FIFO method, your basis is likely even less, particularly if you began accumulating shares several years ago. If that basis is $15,000, you would have a $35,000 capital gain—an even bigger tax hit!
Under the LIFO method, your basis is probably higher because the general trend is that value increases over time. But remember that 2022 was a down year for the market, so if you sell shares that you acquired only recently, you might still have a sizeable gain. Plus, if you sell shares that you acquired less than one year ago, the gain on those shares is a short-term capital gain. Short-term capital gains get taxed at your ordinary income rate, whereas long-term capital gains receive lower rates.
Under the specific lot identification method, you list each lot of VTSAX shares you have ever purchased, and determine the specific ones to sell. Being strategic about which shares to sell can minimize the taxable gain on that $50,000 sale, or perhaps turn it into a loss altogether!
When should I use tax-loss harvesting?
Theoretically, the total gains and losses will be the same in the long run regardless of your basis calculation method, because over time you will sell all your shares of a particular holding (assuming that inheritances, gifts, and donations never enter into the equation).
Tax-loss harvesting allows you to use the gains and losses when it is most advantageous. Return for a moment to the example of the $50,000 VTSAX sale above. It makes sense to minimize the gain if that is your only capital gain for the year and you have other, non-capital gain income. If that $50,000 sale was your only income for the year of any type, though, you would want to maximize the taxable gain this year because of preferential long-term gains rates. By selling the lowest-cost shares now, you leave the highest-cost shares on the table for future years. Trade high gains now for lower taxable gains later.
Another situation where you might want to maximize gains is if you have losses from other holdings or a prior-year carryover. Capital losses offset your non-capital gain income, but only up to $3,000 in a particular year. Any capital losses beyond $3,000 get carried forward until you have offsetting gains. Some folks jump on the tax-loss harvesting bandwagon and seek to minimize their capital gains every time they execute a sale, but they fail to realize that total losses above $3,000 simply carry forward.
The $3,000 limit is an aggregate limit for the entire year; it does not apply to a particular holding or transaction. If you have a $20,000 gain on one holding, and a $22,000 loss on another, you simply have a $2,000 net loss for the year that is fully deductible.
Accumulating losses beyond the $3,000 per-year aggregate limit could make sense if you anticipate a large gain in the near future. But make sure it will be a taxable gain. Inheritances, for instance, typically involve a step-up in basis as of the date of death; if you sell inherited stock shortly after receiving it, you may have only a small gain.
Of course, the reverse is true: You want to minimize the gain, and ideally show a loss, if you have gains from other holdings. That is the power of tax-loss harvesting—you can literally harvest the specific shares to reach your desired result.
This sounds like a lot of work. Is tax-loss harvesting worth it?
Effective tax-loss harvesting requires keeping meticulous records. Even if your brokerage handles the bulk of the work, keep a running spreadsheet of each lot—including dividends reinvested—and what is sold. Sometimes brokerages merge and lose records, and you do not want to be left holding the bag. All it takes is a little bit of extra effort each time you buy more shares or whenever you receive a quarterly statement.
When combined with other techniques, like donating appreciated stock, tax-loss harvesting will help you beat Uncle Sam (legally!) at his own game, both now and in the future, by minimizing or avoiding capital gains taxes altogether. Reach out to me for help charting a long-term strategy so you can enjoy a less taxing life!
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