Selling at a loss is something that many of us have gotten very accustomed to over the last couple of months. With the markets seemingly in nonsensical disarray where certain stocks break their 200 SMAs and the indexes contend with all-time highs, now is a great time to learn how to use this to your advantage.
Selling at a loss is an emotionally painful thing, especially to an investor’s ego when they thought they’d done their due diligence. Despite the agony it may cause, it’s truly an inevitable aspect of investing that we should adapt to work in our favor.
Yes, this is about taxes
When you sell a stock, receive a dividend that isn’t reinvested, or sell other assets like property, you usually incur a capital gains tax on the profit. As we’ve been over and detailed before, capital gains are a tax specifically created for taxing and tracking the sales of equities and assets that lie outside of ordinary income, and something all investors must contend with.
The good news is that, well, the tax code wants you to minimize your tax bill so you’re incentivized to invest, and that’s where tax-loss harvesting (TLH) comes in. It helps you turn a negative into a positive.
How to TLH
When your tax bill is calculated every year, the amount owed is based on your total income from investments, minus your cost basis for those investments. What you paid for the investments is subtracted from what you profited, and because of that, investments that you sold at a loss end up decreasing your tax bill.
By using tax-loss harvesting, you can decrease the amount of your taxable capital gains if you strategically sell positions that are presently sitting at a loss. The amount of money you have in your investment account doesn’t change, it’s just that you’ve converted some open positions into cash instead to pay less in taxes this year.
For example: If you made $10,000 on all sales in your brokerage account this year, but in November you got caught holding the bag on $SNDL again to the tune of $2,000, you can sell that bag and reduce your capital gains income to $8,000. The difference it makes in your tax bill will depend on your income bracket, and if you held the stock for over a year (long-term gains) or not.
It’s way more legal than it sounds
Tax-loss harvesting is perfectly legal. The IRS can’t exactly say “hey guys, you’re not allowed to sell positions that are at a loss in the month of December to decrease your tax bill for 2021.” That would be ridiculous, and investors are allowed to sell regular equities at any given time.
They do try to curtail any blatant harvesting though. The IRS has placed somewhat of a safety net underneath the loss harvesters known as the wash sale rule, which essentially prohibits investors from buying back the same or any “relatively identical” security within 30 days of selling a position at a loss. That “identical” part is where the ambiguity lies, and sometimes open to interpretation.
For most people though, this isn’t an issue, and can easily be avoided by simply staying away from the stocks you sold for the next month before opening your positions back up again. If you missed the run in that time, that’s part of the risk you take, and you have to decide if you’d save more on taxes by taking the loss, or potentially profit more on the investment by holding.
📚 Want to dig a little deeper into TLH? Take this quick and fun bite-size lesson on it: