Tax loss harvesting is the process of selling a security – a mutual fund or stock for example – that has experienced a loss and using that loss to offset a taxable realized gain. The goal of tax loss harvesting is to reduce the amount of tax owed on the gain from the sale of a security or multiple securities. To figure the capital gains tax owed on the sale of a security or multiple securities, the IRS uses a netting process:  Short-term gains (gains on securities held less than one year) are reduced by short-term losses then long-term capital gains (the gain on securities held more than one year) are reduced by long-term losses (securities held for more than one year but sold for a loss). The net result is either a gain or loss, and either short- or long-term. No tax is owed if losses exceed gains. For this reason, investors engage in tax loss harvesting by selling losing positions to offset gains elsewhere in their portfolio and thereby reduce their capital gains tax. This seems like a reasonable idea, but what if an investor has no losses in their portfolio to harvest? 

That generally is a good thing, meaning the portfolio is doing well, but it also means come tax time the investor should expect to pay a capital gains tax if all he or she had were realized gains and no losses to offset, which is not a good thing. (Investors generally dislike paying taxes.) Hence some advisors try to be proactive and book losses whenever they can, even in years where there is no gain to offset. If the investor has unused losses in the current year, the federal tax code allows investors to offset their ordinary income with $3,000 of losses, the balance is carried forward indefinitely for use in future years. Those unused losses may come in handy down the road if there is a year in which the investor has large gains and needs losses to lower their capital gains tax. Investors may try and bank or save up their losses and use them in a year when they really need them. 

Though booking losses for use in future years seems like a reasonable strategy at the federal level, however, it may not be so at the state level. 

For example, if an investor sold a large amount of stocks to pay for college tuition, those stocks sold may incur a large gain. If the investor currently has no losses elsewhere in his or her portfolio, then he or she can use unused losses from prior years to offset the gain and lower their capital gains tax. Hence, harvesting and banking losses in anticipation of using them in the future is a reasonable strategy, after all the investor is at least getting some value from their loss by being able to use it against a future gain. The investor can also buy back the security after 31 days to avoid the wash-sale rule, if he or she really likes the security but wants to realize the loss. Though booking losses for use in future years seems like a reasonable strategy at the federal level, however, it may not be so at the state level. One important caveat that is often overlooked by advisors and investors is whether their home state allows for carrying losses forward. 

Rules vary on the state level

Though the federal tax code allows for carrying forward losses indefinitely, this is not always the case at the state level. In some states like New Jersey, loss carry forwards are not permitted. This means an investor will recognize the realized gain on their state tax return even if the gain was offset on their federal tax return via a loss carryforward. For this reason, if the investor lives in a state that does not permit loss carryforwards, it may not be as beneficial to save or book losses for future years because the investor cannot use them on his or her future state tax return. If an investor resides in a state that disallows loss carryforwards, it may be more beneficial to try and book losses in the current year an investor recognizes the gain. Contrast this to investors in states like New York and Connecticut which allow carryforward losses, harvesting losses for use in future years may make more sense. 

Impact on state taxes

Harvesting losses that are not used in the current year may cause greater harm in a state that disallows loss carryforwards. For example, selling a stock to harvest a loss then buying back the same security or a similar security after 31 days will decrease the investor's tax basis potentially causing a greater taxable gain in the future. By selling the security at a loss and later buying it back, the investor resets their cost basis to the new, lower amount and if and when the security recovers the investor will have a larger future gain. Since New Jersey has a maximum tax rate of 8.97%, this is a very important factor (see Table 1).

Unless the individual is likely to hold the replacing security until they die (and receive a step-up in basis) or move to a no income tax state like Florida, the tax on a future sale of an asset whose cost basis was reduced in a prior tax loss harvest, may end up causing a negative impact greater than any benefit from the loss carry forward realized at the federal level! 

Table 1: Comparing the consequences of different state rules on tax-loss harvesting 

Having a process

Needless to say, prior to implementing any tax loss harvesting strategy, an advisor or investor should not go into it blindly or let their broker harvest losses at will, since a well-intentioned idea may well backfire. Instead, an investor needs to first understand whether their state allows for loss carryforwards. If the answer is no, then booking losses solely for use in future years has less of an appeal. This is also a reason why money managers need to communicate with a client's accountant.

Conclusion

No client is going to get excited about the prospect of paying a capital gains tax, even if it meant they made money in the market. However, tax loss harvesting is an important value-added strategy, and when done properly, a client will appreciate. While I'm not always a fan of booking losses solely for use in future years – after all, you are kicking the tax can down the road, and potentially adjusting the cost basis downward – there are times when an investor may want more losses in the next year. 

For example, if an investor plans on selling a business in the following year or in anticipation of unloading a large tranche of stock to purchase a house are times when an investor will want more losses to offset the large one-time capital gain. Harvesting losses will help in those examples, but not as much in states where the carryforward loss is disallowed. For these reasons, advisors and investors who implement tax-loss harvesting will want to double check their home state's rule on carryforwards so they don't inadvertently trigger more state income tax than they wanted. Now that is an idea worth harvesting. 

Michael Aloi is a fee-based Certified Financial Planner™, Practitioner with 20 years of experience. He has a Master's Degree in Personal Financial Planning and is an Accredited Wealth Management Advisor℠.