What Is Tax Loss Harvesting?

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What is Tax Loss Harvesting?

Harvest of tax loss is when an investor sells a position at a loss to help offset capital gains tax obligations at the end of the year.

To understand what tax loss harvest work is, let’s create a hypothetical portfolio.

It’s December 15th, and here’s your portfolio:

Tax Loss

Here’s the situation, you made good money with two shares and closed those trades, bringing your realized profits to $ 30,000 for the year.

However you still have two open losing trades on ABC and Cyberdyne. You might think that those losses would bring your tax investment income to $ 15,000, but that’s not the case because those businesses are still open, making them unrealized losses, and therefore, ineligible as waste.

So if you’re worried about paying taxes on all of your $ 30,000 in profits, you might want to consider closing your ABC and Cyberdyne businesses (making them realized losses) to reduce your tax investment income.

The practice of strategically closing losing businesses for more favorable tax treatment is known as tax-loss-harvesting.

This is certainly a wise strategy applied by almost all investors, but there is an ongoing question: what if you still want to own ABC and Cyberdyne? Clearly you do, or else you wouldn’t have those businesses open yet.

You may see a possible “hide” here where you close your losing trades on the last day of the year, then reopen said trades on the first of the year. Well, the IRS has already thought about that. It’s called Laundry Sales, participating in Laundry Sales makes those businesses ineligible for waste.

Lava Sales

In the previous section, we established that the IRS has measures in place to ensure that traders do not over-exploit the tax system by making gains on the last day of the year, and then opening an identical business on the first of the year. .

Think of it this way, if you close a business and then open the same business a day later strictly to claim artificial tax loss, that’s pretty unfair.

There is a specific Laundry Rule in the IRS tax code, however, which states that you must wait 30 days before replacing an asset you sold for a loss so that it is not classified as a lava sale.

For example, let’s say you sold some Apple stock for a loss on December 15th, you would need to wait 30 days (approximately until January 16th or more) before you can repurchase Apple stock and still be able to eliminate the losses of yours. December selling.

The IRS also goes a step further by stating that you cannot replace a sold asset with a “substantially identical” asset to avoid the Laundry Sale Rule. An example of this could be if you sold shares of FOXA (Fox Company Class A Shares) on December 15 and bought shares of FOX (Fox Company Class B Shares) the next day.

Although there is no specific guidance on such cases, these two securities are almost identical.

Although this is not tax advice and the tax code is not abundantly clear, many traders use a strategy of selling shares for loss and immediately replace it with similar, but by no means identical, shares. An example of this would be to sell shares like Mastercard for a loss, and immediately replace it with Visa.

Of course, on things like this, you need to consult a tax attorney to find out what you can do, as we are not experts on the duty of the tax code in any way and are not qualified to give you specific things, personalized advice.

Business Strategy on Tax Loss

Tax-loss harvesting is a well-known, repeatable phenomenon in financial markets.

The regulatory code makes this advantageous, and is therefore an element of predictability to the actions of traders and investors around the end of the year. Whenever there is repeatable, predictable behavior, there is potential for a profitable business strategy.

By this I mean to identify the stocks that are the most likely candidates for tax-loss harvest work, and to buy them at the end of the year when everyone is selling them. Then resell them to the harvesters a month later when they want to re-enter.

Identifying Tax Loss Harvesting Targets

This part is relatively simple.

Identify stocks that have declined significantly during the year.

An additional tip I recently received in my inbox from The Macro Tourist is to favor shares with low institutional ownership because “The more the stock is dominated by retail, the more likely the sale of year-end tax losses will be indistinguishable. ” Admittedly, my guess has always been the opposite, but when it comes to this, I trust him.

You can create a simple screen for this on FinViz:

Tax Loss 1

Then it is as simple as finding favorable entry points into these stocks using technical analysis.

Since most of these stocks are in a longer-term downtrend, you can’t think like a trend trader (which is hard for me personally), and instead adopt the average reversal, “buy the dip” mindset. Easier said than done.

Look for trends that have started to weaken and show significant reluctance to make new lows, declining momentum and evolving support level.

Bottom Line

The end of the year is a great time for us to rethink our portfolios. Sometimes we leave losing trades open longer than we should, and sometimes we have to re-evaluate the reasons why we are in business at all.

In general, it is a bad idea to close a good business idea that you are still convinced of, just to reap some tax losses for elimination. Typically, tax-loss harvest work is best suited for those vague businesses you’re looking for a reason to close anyway.

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