Despite all the recent changes in tax law, one provision has remained for many years. Net capital losses are deductible on a client’s tax return, but only up to $3,000 a year. (Up to $1,500 for married taxpayers filing separate returns.)
Thus, if Al Brown has $10,000 in capital gains this year and $30,000 in losses, he’ll have a $20,000 net capital loss for 2013. However, Al’s tax deduction for 2013 will be limited to $3,000.
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Does that mean Al should have taken only $13,000 of losses? Not necessarily. Excess losses ($17,000, in this example) can be carried forward to future tax returns, with no expiration date. Al can use this “bank” of losses to offset net capital gains in 2014, for example, and deduct another $3,000 of excess losses. And so on, in future years.
“We recommend that our clients take excess capital losses, when appropriate,” says Marty James, a CPA who heads an investment and tax management firm in Mooresville, Ind. Similarly, Frank Butterfield, principal at Homrich Berg, a wealth management firm in Atlanta, says, “We usually harvest losses well in excess of the amount deductible in a single tax year because the losses may be carried forward to use in future years. We view the loss carry-forwards as assets.”
Financial asset prices have generally increased in the last five years, Butterfield points out, so there haven’t been great opportunities recently for clients to recognize capital losses. “We did harvest many losses,” he says, “when financial asset prices were down sharply in the last two major bear markets of 2000-2002 and 2008-2009.”
James also says that his clients took large amounts of losses in 2008 and 2009, which they’re still using to offset any realized gains. With a bank of tax losses, clients can take gains when indicated by investment concerns, without worrying about incurring taxable gains.
“We can maintain our allocations when tax loss harvesting by purchasing similar (but not identical) securities on the same dates that we sell for losses,” says Butterfield. That will avoid a wash sale, which prevents a current tax break for the loss.
Another way to avoid a wash sale is to sit on the sideline for 31 or more days and then buy back a security that’s still desired. “However,” says James, “such a buyback lowers a client’s basis, which will result in a higher tax on a future sale. You have to determine whether the entire process is worthwhile.”
Current tax law might encourage tax loss harvesting, especially for high-income clients. Not only do they face higher tax rates, they also may owe the 3.8% Medicare surtax on net investment income as well as the tax increase from the phaseouts of personal exemptions and itemized deductions. The higher the effective tax rate on reported capital gains, the greater the benefit of tax deferral. “This tactic can be very helpful,” says James, “if the taxable gains can be deferred until clients are retired and their income may not be over all these thresholds for higher taxes.”
James also notes that tax losses realized from a securities portfolio can be used to offset capital gains from other transactions, such as a business sale. “If we expect a client to have a major taxable event, some years in the future, we will begin now to accumulate losses to offset that gain,” he says.