Harvesting tax losses is something most investors know about. But like dieting and exercise, it is easy to put off, causing foot-dragging among stock and fund holders who miss out on a tax break.
While losses can be taken anytime during a year, November and December are common because the year's investing results are pretty clear. Since the long rise in stocks has left many investors with big gains, it may be especially valuable to hunt for offsetting losses before this year's Dec. 31 deadline.
Most ordinary investors use mutual funds and exchange-traded funds rather than individual stocks, and many avoid taking losses because they've been told over and over not to try timing the market and to instead ride out downturns. Many also don't want to miss a rebound and shy away from booking losses, because the government's "wash sale rule" can disallow a tax loss if the same security or one "substantially identical" is purchased within 30 days before or after the sale. You cannot sell and immediately buy the same security to ride a rebound and still claim the loss.
Experts say tax-loss harvesting is still a sound and basically conservative strategy. With ETFs, there are better opportunities now for fund investors to enjoy rebounds during the 60-day wash-sale period by purchasing a stand-in ETF that should behave just like the security they sell.
"If we are selling out of a large-cap growth mutual fund, for example, we will purchase an ETF that mirrors a large-cap growth index," said Divam N. Mehta, founder of Mehta Financial Group in Glen Allen, Virginia. "By executing this type of transaction, we are able to not only stay in the market but also stay invested in a similar asset class without running afoul of the wash-sale restriction. ... We should be able to find an ETF that will replicate the sold asset."
Loss harvesting means selling a holding that's worth less than you'd paid for it. The loss can be subtracted from gains on other investments sold during the year to reduce taxes, "carried forward" to offset gains in the future, or used to reduce ordinary taxable income by up to $3,000 in the current or future years.
The tricky part comes with the desire to ride a recovery. The wash-sale rule says if you sold General Motors, you can't get the tax loss if you buy GM during that 60-day period. For mutual fund investors, the problem can be even worse, because many fund companies — to reduce turnover that raises expenses and trigger tax bills for other investors, ban quick in-and-out trading — sometimes with a waiting period as long as six months.
But if you cannot sell GM and buy it right back, you could buy Ford instead, in the hope another car stock would behave much like GM. In the same way, an investor who sells Fund A can buy Fund B. ETFs are useful in these strategies because they are not as likely as individual stocks to diverge from the holding they replace because of unique factors like a lawsuit or loss of an executive.
"By keeping your investment constant, you will not miss a jump in the market and are simply taking advantage of the tax benefits," said David Hryck, a tax lawyer with Reed Smith in New York City. "If you're still confident that the sector [you have a loss in] will turn [around], you could sell the losing investment and buy an ETF in the same sector."
Here are strategies, from simple to not so simple, for getting around the wash-sale rule:
1. Double up.
If you wanted to sell 100 shares of XYZ to book a loss, you could buy another 100 shares more than 30 days before the sale, sell the first 100, and use the second batch to enjoy any rebound. This can be expensive but satisfies the rules. Be sure to tell your broker or fund company to sell the older shares, and ask if that instruction should be in writing.
2. Buy an ETF that behaves the same.
Since ETFs trade like stocks and can be bought or sold all day, an ETF stand-in can be held for as short or long a period as needed.
The rule barring "substantially identical" securities still applies, so don't use an ETF tracking the S&P 500, such as the SPDR S&P 500 (SPY), to stand in for a mutual fund tracking the S&P 500. Use an ETF that tracks the Dow or some other index of large U.S. stocks. Use Morningstar.com's ETF Screener to find ETFs in specific categories. It shows 30 ETFs holding large-growth U.S. stocks, for example.
Be aware that the rules on what is substantially identical are subject to IRS rulings that make them quite tricky.
Imagine, for example, you wanted to book a loss on gold while staying in the market. The SPDR Gold Shares ETF (GLD) is trading around $116 a share, up 20 percent this year but far below the peak of $177 in 2011, or even this year's high of $129 in July. So an investor who bought GLD during a period it was higher could book a nice loss now.
Gold investors "have done pretty well this year but are still sitting on a loss," said Ed Coyne, executive vice president at Sprott Asset Management USA, a registered investment advisor based in Carlsbad, California, and an affiliate of Sprott, a global alternative asset manager. The firm manages the Sprott Physical Gold Trust (PHYS), an exchange-traded trust that represents ownership of gold bullion stored in the Royal Canadian Mint.
Coyne said investors who sell GLD can buy PHYS to stay in the market. Sprott believes they would escape the wash-sale rule because PHYS is a closed-end trust, while GLD is an open-ended fund — they are not substantially identical. (As a bonus, gains in PHYS are taxed as ordinary capital gains, at rates of 15 percent or 20 percent for long-term holdings, while GLD gains are taxed at the 28 percent rate on collectibles, Coyne said.)
Of course, in a similar case, the IRS may not feel that two very similar securities are different enough, so investors should be careful about treading a fine line.
3. Buy a call.
A call stock option gives its owner the right to buy 100 shares of stock or an ETF at a set price for a given period. If the stock or ETF rises in value, the call contract will go up as well. So the investor who sold XYZ for a tax loss can buy a call on a similar but not identical security to stay in the market. Because options cost far less than the underlying security, buying one contract would cost a fraction of the cost of buying 100 shares of the real thing.
Here's where it gets tricky: You could instead buy a call on XYZ itself rather than something different, guaranteeing your stand-in would track XYZ exactly. A call on the same holding you sold would be considered substantially identical, so the loss on XYZ could not be taken if the call were purchased within 30 days before or after the sale.
But the strategy could work anyway by effectively switching the loss to the call, said Robert N. Gordon, president of Twenty-First Securities, a brokerage in Manhattan.
In his example, an investor who bought XYZ for $50 sells at $30 for a $20 loss. At the time of the sale, the investor buys an XYZ call with a strike price of $35, paying $1 a share and gaining the right to buy 100 shares of XYZ for $35 each to ride a rebound.
The investor cannot claim the $20 loss on XYZ, because of the call purchase, but can add that $20 to the cost basis of the call, raising its price for tax purposes to $21. If the call were then sold for $1, the investor could claim a $20 loss on the call instead of claiming it on the XYZ shares sold earlier.
This move would also allow the investor to buy back the XYZ shares as soon as the call is purchased, to stay in the market, while still staying clear of wash-sale problems, Gordon said. He added that to avoid being substantially identical, the call must be "out of the money" — have a strike price higher than the price at which the security is trading.
"I think a lot of people try to do loss harvesting and probably would be well served to understand what the rules are before they do," he said. "You have to be correct."
— By Jeff Brown, special to CNBC.com